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Business interruption insurance. (Re-Examining).

This is the first of three articles that will address business interruption (BI) insurance as part of the Crisis Management Series. In this installment, the authors examine the evolution of today's BI insurance terms and conditions; the three classes of policies generally available before September 11, 2001; the potential exposures; and the legal precedents that may hold a clue to coverage determination. Coming in March and April: "Risk Management Best Practices for Preparing BI Claims" and "Resolving BI Claims Fairly while Preserving Market Relationships."

Business interruption (BI) insurance has been available for over a century. The earliest policies covered rental value, a notion tied to the physical destruction of real property. Use and occupancy insurance policies were introduced later to protect the manufacturing earnings stream. Under early use and occupancy policies, the amount of loss correlated directly with the extent of direct damage to property. From there, a transition was made to calculate BI loss on the basis of a fixed daily value.

The 1920s saw the last great revision of the BI policy form. With the manufacturing economy in full swing, an effort was undertaken to create a form that would indemnify the insured for its actual loss of earnings. The term selected to embody this concept was "actual loss sustained," meaning, in the view of the late Clyde Kahler, the highly regarded professor of insurance at The Wharton School of the University of Pennsylvania in Philadelphia, "the loss of earnings consequent to the peril insured against." In this simple concept, however, great complexity was embedded. Without the safety net of the valued form in place, just how would actual loss sustained be determined?

The framers devised an elegant solution still used as standard language in manuscript policies today: By giving "due consideration to the experience of the business before the date of damage and the probable experience thereafter had no loss occurred," the insured and insurer could reach reasonable accommodation regarding the actual loss sustained. Based on past experience and the future probable experience, the insured loss could be determined in a commercially reasonable manner. From this principle, courts articulated the widely accepted purpose of BI insurance: to do for the insured what it would have done for itself had no loss occurred.

Three Classes of Policies

Unlike standard form commercial liability insurance policies, first party property and BI insurance policies lack the uniformity businesses would expect from a worldwide system of risk management. Thus, the precise language of a given insurance policy must be examined before any coverage conclusions can be drawn.

The vast majority of small and midsized businesses in the United States are insured under BI forms developed by the Insurance Services Office (ISO). These standard forms embody what is perhaps the most carefully crafted (and in many respects, the most restrictive) language of any BI policy.

Insurers that specialize in covering highly protected risk (HPR) issue their own policy forms containing language unique to their underwriting requirements. These policies generally expand the coverage provided under the ISO forms to meet the needs of more sophisticated and complex risks. The HPR forms may also contain language covering novel loss situations, such as earnings lost while access to insured property is prevented by physical damage to adjacent property.

A third category of policy forms--manuscript policies--provides the broadest coverage available. These have been developed and marketed for many years by the major international insurance brokers and contain unique terms and conditions. The recent competitive marketplace aided greatly in their proliferation.

The September 11 Attacks and Resulting Business Interruptions

Before September 11, the largest insurance event on record was Hurricane Andrew, which caused insurable losses of approximately $22 billion, taking into account inflation. Although a number of large commercial claims were among those paid, Andrew largely affected homeowners and featured many small claims with minimal BI impact. By way of contrast, the events of September 11 will result in billions of dollars of insured physical damage losses and billions more in associated BI losses. A number of individual losses are expected to exceed $1 billion.

Also unique are the extraordinary loss situations that have arisen: hotel chains are measuring losses at resort hotels due to the Federal Aviation Administration ban on air travel; manufacturers are assessing financial damages incurred when just-in-time inventory systems were disrupted by border closures; and retailers are analyzing losses attributable to changes in buying patterns precipitated by the attacks.

These circumstances have triggered potential coverage under previously underutilized provisions--service interruption, contingent BI, interruption by civil or military authority and ingress/egress--and also raise the question of whether losses are recoverable if the business sustained no physical damage to either its insured or described property.

The Necessity for Direct Physical Loss or Damage to Insured or Described Property

A relatively small number of businesses sustained direct physical loss as a result of the events of September 11. Will business interruption recovery be possible for loss incurred by a business that did not sustain direct physical loss or damage to property either insured or described in its BI policy? The answer is found in the specific language of the insurance policy at issue.

For example, the standard ISO business income coverage form reads:

"We 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 at the premises described in the Declarations...caused by or resulting from any Covered Cause of Loss." (Emphasis added.)

Under this form, insurance companies contend that the suspension of operations and corresponding loss of business income must be caused by direct physical loss or damage to property described in the declarations.

Other BI policy forms, however, are not so restrictive. For example, in Archers-Daniels-Midland Co. v. Phoenix Assurance Co. of New York (1996), ADM sought coverage for extra expenses when flooding of the Mississippi River and resulting crop damage caused ADM to incur increased transportation and raw materials costs. The insurance policy at issue read:

"Extra Expense sustained by the insured as a result of direct physical damage caused by the perils insured against under this policy and not excluded elsewhere in this form..."

ADM argued that there were only two preconditions to coverage: (1) the extra expense was incurred as "a result of direct physical damage" that was (2) "caused by the perils insured under this policy." The insurance company countered by arguing that the extra expense provision was limited to situations in which the insured's described property was damaged.

In holding in favor of ADM, the federal court reasoned that when the insurance company wanted to limit coverage to either insured or described property it did so expressly, as was done explicitly for other provisions of the policy.

"In the case at hand, the [insurance company] could have insisted that coverage under the [extra expense] provision be limited to extra expense incurred as a result of damage to property at scheduled locations, but they did not," the court stated. "Such a requirement was stated in at least nine other places in the policy. After the insured has sustained a loss is too late to add such a restriction."

Contingent Business Interruption

Contingent business interruption and contingent extra expense coverage reimburses lost profits and extra expenses resulting from an interruption of business at customers' or suppliers' locations. Coverage is generally triggered by physical damage to the property of the dependent customer or supplier, or to property upon which the insured depends to attract customers. The extent of loss is based on the time required to repair or replace the dependent property.

In one of the few, if not only, cases decided under a contingent BI clause, the court in the ADM case concluded that Midwest farmers and the United States government were suppliers of goods and services to ADM and that ADM was entitled to coverage when flooding prevented those suppliers from supplying it with necessary raw materials and transportation services.

Interruption by Civil or Military Authority

Interruption by civil or military authority coverage reimburses policyholders for BI losses incurred when access to property, usually the insured premises, is affected by an order of a civil or military authority following a specified event. Potentially, no coverage extension has broader implications for September 11 claims.

Under ISO language, coverage is limited to losses incurred, after a seventy-two-hour waiting period and limited to three consecutive weeks, when action of an authority "prohibits access to the described premises due to direct physical loss or damage to property caused by a covered cause of loss." HPR policies are similarly worded, with some containing additional restrictions on the location of the property damage that triggers coverage, such as within one thousand feet of the insured premises.

The broker manuscript forms broaden coverage in many respects. First, many policies contain no time period limitations. Those manuscript policies that do contain time period limitations may provide for up to sixty days of coverage. Second, the word "prohibit" ("to forbid by authority") has in many cases been replaced by the word "impair" ("to make worse by diminishing in some material respect"). Third, while ISO and HPR forms state physical damage must give rise to the action by an authority, broker manuscripts are not as restrictive and often refer to governmental orders made "following or in connection with a peril." Also; some policies replace the phrase "access to the described premises" with "access to real or personal property," without specifying the location or ownership of the property to which access is prohibited.

Courts around the country are split on the issue of whether coverage for interruptions caused by orders of civil and military authorities requires physical damage. Compare Bros., Inc. v. Liberty Mut. Ins. Co. (1970) (no coverage absent physical damage to property) with Kilroy Indus. v. United Pacific Ins. Co. (1985) (coverage found notwithstanding absence of physical damage to property).

Ingress/Egress

Ingress/egress coverage is similar to the coverage provided for interruptions caused by civil or military authorities, absent the requirement of governmental action. It is not available under ISO forms, is in some HPR policies and is most prevalent in broker manuscript policies.

There is one reported interpretation of ingress/egress in the context of BI insurance. In Fountain Powerboat Industries, Inc. v. Reliance Ins. Co. (2000), the court noted the paucity of case authority on this issue, stating that "this is due to the fact that the meaning of the clause is exceedingly clear."

In Fountain Powerboat, access to the policyholder's facility was impaired after Hurricane Floyd caused flooding of the only road leading to the location. As in the ADM case, the insurance company argued that coverage was available under an ingress/egress clause only if there was physical damage to the policyholder's facility. The court rejected the insurance company's contention: "the court finds no requirement for physical loss to the [insured] property is required under the contract of insurance in order to trigger BI coverage under the ingress/egress clause."

Service Interruption

Service interruption coverage pays for losses due to the interruption of incoming utilities caused by physical damage to property that supplies utility services, such as communication transmission lines, microwave relays, transformers and substations.

This coverage is available under the ISO form by endorsement. Some company policies require that the off-premises utility equipment be within one thousand feet of the insured property. The broker manuscripts generally contain no such limitation, and service interruption coverage is written with specific sublimits of liability.

In Thornton-White, Inc. v. Industrial Risk Insurers (1981), the policyholder's business was interrupted when Hurricane Hugo knocked out the transmission lines within five hundred feet of the policyholder's business. The insurance company denied coverage by arguing that even if the transmission lines were not knocked out, the policyholder's business would nevertheless have been idle because the local utility was unable to provide service to the community generally.

In rejecting the insurance company's contention, the court held: "The [insurance company] cannot deny coverage by postulating that the hurricane would have interrupted electrical power generally even if it had not damaged Plaintiffs transmission lines. [The insurance company] does not know this and, by the very nature of the circumstances, such a proposition is necessarily speculative and cannot be proved."

Extended Period of Indemnity

The purpose of extended period of indemnity (EPI) coverage is to restore the business to the condition that would have existed had no loss occurred. This coverage begins when the underlying BI coverage ends, and is typically purchased in thirty-day increments. It is not uncommon for policies to provide up to two years of additional coverage.

In a landmark decision, the court in Fountain Powerboat ruled that EPI coverage was also available in the case of ingress/egress loss. In holding for the insured, the court stated:

"[T]he length of time for which loss of ingress/egress may be claimed is the length of time to restore Fountain's business to the condition that would have existed had no loss of ingress/ egress occurred."

Future Implications

Twenty-four thousand businesses operated in lower Manhattan before September 11. Many thousands more depended on those businesses as buyers and sellers. Disruptions in utility services affected financial institutions worldwide. The FAA ban on air travel brought whole industries to the brink of bankruptcy.

Initial estimates of insurable losses were $25 billion to $30 billion. Revised estimates are now as high as $70 billion and even $100 billion. The full extent of business interruption losses remains uncertain.

Notwithstanding these projected losses, the insurance industry is expected to have a banner year. David Hale, chief economist at Zurich, Switzerland-based Zurich Financial, predicts commercial property/casualty premiums will double in the coming year to $300 billion. Add another $20 billion or so in fresh capital, governmental guarantees (or bailouts) and improved combined ratios, and the insurance industry is likely to be awash in cash--vastly more than enough to cover even the most inflated forecast of September 11 claims. It is clear where the money to pay for the losses will come from.

In the short term, risk managers will be asked to absorb higher premiums, higher deductibles, terrorist exclusions, loss of blanket limits, more restrictive terms and conditions, sublimits and perhaps even the elimination of indirect coverage such as ingress/egress. With reinsurance capacity at issue, and the ultimate liability for claims unknown, the markets are simply not willing to engage in business as usual.

Due to their size and complexity, September 11 BI claims will not likely be resolved any time soon, which may not be a bad thing. Risk managers should be patient until the markets settle, when they may end up using their exotic BI claims to leverage lower premiums when renewing policies. Risk managers holding broad coverage wording and unresolved BI claims might cause the market pendulum to swing back, and if the economy recovers in 2002, could well create the shortest hard market in history.

Other BI Coverage Features

* Rental Value

* Leasehold Interest

* Extra Expense

* Extra Expense Incurred to Reduce Loss

* Expediting Expense Provisions
 ISO Form

Coverage Trigger Necessary suspension of operations caused
 by direct physical loss of or damage to
 property at the premises described in the
 declarations

Loss Insured Actual loss of business income consisting
 of net income and continuing normal
 operating expenses

Period of Interruption Begins seventy-two hours after loss and
 ends when damaged property could be
 repaired with reasonable speed and similar
 quality

Extended Period of Begins when damaged property is repaired
Indemnity (EPI) and ends the earlier of when operations
 are restored or thirty days (or selected
 time)

EPI Exception No coverage for losses incurred as a
 result of unfavorable business conditions
 caused by the impact of the covered loss

Extra Expense Necessary expenses incurred during the
 period of restoration that would not have
 been incurred if there was no physical
 loss or damage to property

Rental Value Actual loss of total anticipated rental
 income from tenant occupancy, tenant
 charges and fair value of insured's
 occupied premises

Leasehold Interest Net present value of rent differential
 plus unamortized lease acquisition costs,
 improvements and betterments, and prepaid
 rent

Civil Authority Loss incurred after seventy-two hours and
 limited to three consecutive weeks when
 action of civil authority prohibits access
 to described premises due to direct
 physical loss or damage to property caused
 by a covered cause of loss

Ingress/Egress None

Contingent Business By endorsement; actual loss of business
Interruption income due to necessary suspension of
 operations during period of restoration
 when suspension is caused by direct
 physical loss of or damage to dependent
 property at a premises described in the
 declarations

Service Interruption By endorsement; loss of business income or
 extra expense at the described premises
 caused by interruption of service caused
 by direct physical damage by a covered
 cause of loss to specific types of utility
 services property

Consequential/Remote Increase of loss caused by or resulting
Loss Exclusion from suspension, lapse or cancellation of
 license, lease or contract, unless
 suspension is directly caused by the
 suspension of operations, then coverage is
 provided for loss incurred during period
 of restoration

 HPR Form

Coverage Trigger Necessary interruption of business caused
 by physical damage of the type insured to
 real or personal property of the type
 covered located at the described premises

Loss Insured Actual loss sustained of gross earnings or
 of net profit and expenses that
 necessarily continue

Period of Interruption Begins at time of loss and ends when
 damaged property could be repaired or
 replaced using due diligence and dispatch

Extended Period of Begins when damaged property is repaired
Indemnity (EPI) or liability otherwise ceases and ends the
 earlier of when operations are restored or
 thirty days (or selected time)

EPI Exception None

Extra Expense Reasonable and necessary extra expenses
 incurred during a period of restoration to
 temporarily continue as nearly normal as
 practicable the conduct of the business

Rental Value Actual loss sustained of fair rental value
 of property occupied by the insured,
 income expected from rentals of unoccupied
 space and rental income from rented
 portions, less noncontinuing expenses

Leasehold Interest Actual rent payable for the unexpired term
 of the lease or lease interest for the
 unexpired term of the lease

Civil Authority Loss incurred, not to exceed two
 consecutive weeks, when as a direct result
 of damage of the type insured against,
 access to described premises is
 specifically prohibited by order of civil
 authority

Ingress/Egress By endorsement; actual loss sustained when
 access to insured locations is prevented
 due to loss or damage of the type insured
 against

Contingent Business Actual loss sustained during a period of
Interruption interruption directly resulting from
 physical loss or damage of the type
 insured against to property of the type
 not otherwise excluded at direct supplier
 or customer locations

Service Interruption Loss resulting from physical damage of the
 type insured against to electrical
 transmission lines and other electrical
 equipment and steam and gas transmission
 lines outside the premises but within one
 thousand feet thereof when used
 exclusively by the insured

Consequential/Remote Increase of loss resulting from the
Loss Exclusion suspension, lapse or cancellation of any
 license, lease, contract or order unless
 such suspension results directly from the
 interruption of business, then there shall
 be liability for only such loss as affects
 the insured's earnings during the period
 of indemnity

 Broker Manuscript

Coverage Trigger Necessary interruption of business caused
 by loss, damage or destruction by perils
 insured against to real and personal
 property

Loss Insured Actual loss sustained of gross earnings or
 of net profit and expenses that
 necessarily continue

Period of Interruption Begins at time of loss and ends when
 damaged property could be repaired or
 replaced using due diligence and dispatch

Extended Period of Begins when damaged property is repaired
Indemnity (EPI) or liability otherwise ceases and ends the
 earlier of when operations are restored or
 one year (or selected time)

EPI Exception None

Extra Expense Excess of the total cost during the period
 of restoration of the damaged property
 over and above the total cost that would
 have been incurred had no loss occurred

Rental Value Reduction in rental value less charges and
 expenses that do not necessarily continue
 during the period of untenantability

Leasehold Interest Pro rata proportion of the insured's
 interest in bonuses or lease acquisition
 costs, improvements and betterments to
 real property, and advance rental payments

Civil Authority Loss sustained when access to real or
 personal property is impaired by order of
 civil or military authority following or
 in connection with a peril insured against

Ingress/Egress Loss sustained when access to real or
 personal property is impaired following or
 in connection with a peril insured against

Contingent Business Loss resulting from damage to or
Interruption destruction by the perils insured against
 of property that directly or indirectly
 prevents a supplier of goods and services,
 or property that prevents a receiver of
 goods and services from accepting
 the insured's goods and services

Service Interruption Loss resulting from the interruption of
 electricity, steam, gas, water, sewer,
 telecommunications or any other utility
 or service resulting from damage to or
 destruction caused by an insured peril
 that prevents in whole or in part the
 delivery of such utilities

Consequential/Remote Increase of loss occasioned by the
Loss Exclusion suspension, lapse or cancellation of any
 lease, license, contract or order except
 with respect to loss directly resulting
 from the interruption of business as
 affects earnings during the period of
 interruption


John D. Dempsey is the managing partner of Dempsey, Meyers, and Company, LLP. Lee M. Epstein is a partner with Fried & Epstein.

John D. Dempsey, CPA, CFE, is the managing partner of Wilton, Connecticut-based Dempsey, Myers, and Company LLP, a nationwide CPA firm that specializes in preparing business interruption insurance claims. (johndempsey@dempseymyers.com)

Lee M. Esptein is a partner with New York-based Fried & Epstein, a law firm specializing in the representation of policyholders in insurance coverage disputes.
COPYRIGHT 2002 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Dempsey, John D.; Epstein, Lee M.
Publication:Risk Management
Geographic Code:1USA
Date:Feb 1, 2002
Words:3657
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