In a recent case, Rad Source Technology Inc. v. Colony National Insurance Co. (Fla. App. Nov. 2, 2005), a manufacturer of blood irradiation machines shipped one to a customer, a university medical facility. During transit, the machine was damaged, and the customer sued. The manufacturer turned to its liability insurer and asked for a defense, which was refused. The Florida Court of Appeals, however, held that the insurer had a duty to defend the suit. One basis for the carrier’s coverage denial was the injury-to-products (or “own products”) exclusion. That exclusion bars coverage for property damage to “your product” arising out of it (or any part of the product). As the court found, the exclusion is meant to bar coverage for “situations wherein the product itself is defective.” Slip op. at 4. The court found the exclusion inapplicable because there was no allegation that the product itself was the source of whatever damage occurred. Because the allegations were not confined to a claim that an endogenous risk led to the damage, one could reasonably construe the complaint to allege exogenous risk, which is covered.

The carrier also denied coverage on the ground that the contractual-liability exclusion applied. This exclusion bars coverage in the event that the insured assumes via contract liabilities that it would not otherwise have at tort (in other words, it applies to circumstances where the policyholder for consideration becomes an insurer for someone else). Here, the manufacturer had agreed to assume the risk of loss until the product was delivered to Atlanta (“F.O.B.”), and the facts of the case showed that that product was damaged after it had reached Atlanta. As a result, the seller had not assumed the risk of the loss at issue via its sales agreement, and therefore the contractual liability exclusion did not apply. Thus, the court concluded there was a duty to defend.

The Rad Source Technology case addressed liability insurance coverage; as noted, manufacturers may insure against the risk of loss while they retain title in their products during transit under first-party coverage. The case for insurance recovery is straightforward where the goods are destroyed; but sometimes goods can be affected by conditions during shipment that affects their value such that the insured will claim loss.

In a recent case, American Home Assur. Co. v. Merck & Co., Inc., __ F. Supp. 2d __, 2005 WL 22206797 (S.D.N.Y. Sept. 12, 2005), a pharmaceutical manufacturer claimed losses in three unrelated circumstances arising from its decision to destroy products that were either damaged or exposed to inappropriate shipping conditions during transit.

The policyholder, Merck, engages in a highly regulated business, and it faces a high risk of legal-liability claims. For any pharmaceutical manufacturer, the risk of third-party liability and claims for punitive damages is severe if it is lackadaisical about knowledge that components of product have been contaminated, damaged, or inappropriately stored. Given the legal environment in which it operates, Merck must be sensitive also to managing its risk of regulatory violation stemming from any alleged lack in care in the stewardship of its products. Accordingly, in purchasing its first-party property policy, Merck sought to retain control of the decision of what to do when there was a risk that its products were damaged or degraded during shipping.

The clause at issue in particular

(i) assigned to Merck a right of possession for any damaged goods and to retain control over them,
(ii) made Merck the “sole judge” as to whether the goods were “fit for use”,
(iii) vested in Merck the power to dispose of the goods as it saw fit (subject to the insurer’s right of salvage).

Goods were deemed to have suffered a loss that triggered the coverage

(i) if the product in fact was condemned by government authority, or
(ii) if Merck concluded that a reasonable construction of the applicable law would require that the goods no longer be considered fit for sale, or
(iii) if the only means to determine whether the goods were unfit is through destructive testing.

Moreover, the policy included a “sue and labor” clause, that is, a clause that affords the insured the opportunity to obtain reimbursement for the costs it incurs in avoiding further loss to covered property.

The losses involved three unrelated situations, but each had in common that Merck had shipped a component of a pharmaceutical product and during shipment some untoward event occurred that led Merck to conclude that part or all of the shipment no longer could be used. For one of the claims, a temperature indicator showed that for part of its journey the product had been exposed to temperatures below what had been prescribed. Concerned that the product (vaccine) had been frozen, Merck concluded that the product in the truck could not be used or resold. (This conclusion was based on its interpretation of 21 C.F.R. 211.208.) The insurance company, however, disputed that any of the vaccine had been frozen in fact, that the regulation applied to vaccine, or that the regulation prohibited testing and rehabilitation of vaccine even if a portion was not usable.

Another of the claims concerned the shipment in the same truck of a poison with pharmaceutical product; Merck concluded that FDA regulation prohibited such transport, and it ordered destruction of the entire shipment even though there was no evidence of actual contamination of its product. Again, the insurer challenged the reasonableness of Merck’s conclusion and conduct.

The final claim involved product that was shipped in fiberboard drums. Four drums that were shipped by airplane were thought to be damaged; for two drums, the plastic liner containing the active pharmaceutical ingredients (“APIs”) was breached, but for the other two drums, which were themselves damaged, there was no evidence of any injury inside of the drum (e.g., the plastic liner was intact). Merck did not test the material in any of the four drums and instead destroyed all four on the grounds they had been subjected to improper storage conditions within the meaning of 21 CFR 211.208. The insurer questioned Merck’s actions here, too.

The court refused to grant summary judgment, in part criticizing Merck for its failure to involve its insurer, particularly in determining whether there might be salvage value to the affected product. The court did not seem comfortable with the idea that the insurer was subsidizing Merck’s (reasonable) decision to be conservative in handling its product by destroying it whenever there was objective evidence calling into question the product’s integrity during shipment. Because the interest of the insurance company was implicated, the court seems to imply that Merck needed to be attentive to the interest of this constituency too. While Merck plainly was vested with considerable discretion, the court seemed to question whether Merck was acting as a “prudent uninsured” throughout the process or whether it destroyed the material prophylactic ally in part in the belief that its insurance would cover the loss.

When it purchased the coverage, Merck had sought initially to amend the policy form to afford it broader latitude than its rights and responsibilities under the policy language ultimately agreed. Accordingly, while it was entirely sensible to place Merck in charge of the product and of ensuring its own compliance with FDA regulation, the provision gave the insurer some interest in the disposition of damaged product for which it was expected to pay. The lesson here is that managing the relationship with the insurer needs to be accounted for in the insured’s business processes of handling situations like these. The risk-management department must ensure not only that coverage is purchased but also that the company’s business practices conform so that the right to insurance recovery is safeguarded – and the risk of litigation with one's insurer is reduced.