No company operates in isolation: it has suppliers and it has customers. And damage to either can have devastating effects on the business. Accordingly, another form of coverage is available that indemnifies the insured for upstream (supply) and downstream (customer) loss that affects the company’s profitability. This type of insurance is known generally as contingent business interruption insurance.

The increasing movement toward just-in-time systems for inventory and supply-chain management has heightened the risk of a loss from a hiccough in the smooth flow of inputs, and contingent business interruption insurance seemingly has become more common. There have been relatively few decisions to date on the coverage, but the United States Court of Appeals for the Eighth Circuit recently addressed this coverage in the case of Pentair Inc. v. American Guarantee and Liability Ins. Co., (8th Cir. March 11, 2005).

Pentair involved a company whose foreign supplier was unable to operate due to a loss of electricity stemming from an earthquake. (Actually there were two suppliers, but the facts are identical.) The supplier’s property was not physically damaged; the electrical substation was damaged. The Eighth Circuit’s majority opinion holds that the insured’s contingent business interruption insurance did not apply to indemnify it for certain losses stemming from the supplier’s being shut down as a result.

The court ruled that the supplier’s property did not suffer “direct physical loss or damage” that would trigger coverage. In reaching this conclusion, the court reasoned that loss of function of physical property is not itself physical loss. (The court misreads one case it sought to distinguish on this ground, General Mills v. Gold Medal Ins.¸622 N.W.2d 147 (Minn. App. 2001), which does hold that impairment of function is physical loss. Cf. National Children’s Expositions Crop. v. Anchor Ins., 279 F.2d 428, 430 (2d Cir. 1960) (“”It is true that there might be liability [under a business interruption policy] in the absence of actual physical damage.”).) The Pentair court holds that in the absence of physical damage to the supplier’s property there was no coverage, a conclusion reinforced by the foreseeability of a loss due to off-premises power interruption and the policy’s silence in this regard. As the court said, “[e]xtending that coverage to Pentair losses resulting from power outages at unknown third party supplier premises, which may be located all over the world, insures a different and presumably more substantial risk.” (slip op at 7). The court distinguished the facts from circumstances where the other property functions only as some sort of intermediary that passes through material, where coverage has been found in other cases where the “remote” supplier suffered damage, e.g., Archers Daniels Midland v. Phoenix Assur., 936 F. Supp. 534, 537 (S.D. Ill. 1996); the Eighth Circuit reasoned that the electricity was not passed on to Pentair in the same way as a middleman passes on the material or product from a remote supplier.

Note that generally contingent business interruption coverage requires that the loss arise from an insured peril. What this means is that, even if the insured does not itself face, e.g., a risk from earthquakes, unless its policy covers earthquakes risks, its contingent business interruption coverage will not apply if an earthquake damaged the covered supplier’s property.

Pentair underscores that, in deciding on the scope of coverage, policyholders need to identify: (i) the risks of loss that trigger the coverage; (ii) the other properties that one is concerned about (what is sometimes called the “dependent” property, or in Pentair the supplier’s property and operation); and (iii) the nature of the loss to the dependent property that triggers the coverage (e.g., whether off-premises power loss is covered). Generally, only physical damage from an insured peril to the dependent property falls within coverage. In fact, one may find that utility services are excluded from the definition of dependent property (or in the case of suppliers what is called the “contributing location”); utility-service interruptions as in Pentair may be covered by an endorsement for “Utility Services – Time Element” coverage. (Where service-interruption insurance is purchased, policyholders should make sure that it goes all the way back to the utility, and not just some artificial set distance from the covered location.)

A more expansive form of coverage that would pick up losses such as in Pentair is known as Trade Disruption Insurance, which guards against the risk of loss from the supply or distribution chain (more or less) however caused.

Another issue with contingent business interruption coverage is that the policy limit often is only a fraction of the amount for business interruption stemming from damage to the insured’s own operations. But the loss of a critical input can reduce profits every bit as much as can a fire at the insured’s property, so it is important to assess the suitability of the amount of coverage that is being purchased.