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March 2, 2007

Appraising Appraisers and Appraisals

In many property-insurance policies, a party has a right to demand an appraisal, which is procedure in which the value of lost or damaged property is determined. Typically, an appraisal takes the form of what I call a 1 + 1 + 1 structure – each party appoints its own appraiser, and if the two party-appointed appraisers cannot agree on a number the two together then select an umpire (or a court will select an umpire to decide if the two cannot agree on one). That some form of alternative dispute resolution is used for valuation, however, does not mean that there is no room for judicial intervention in disputes involving insurance policies with appraisal provisions.

As with other forms of ADR, courts say they seek to minimize on review their own scrutiny of appraisal process and outcomes. E.g., Emmons v. Lake States Ins. Co., 284 N.W.2d 712 (Mich. App. 1992). Appraisal proceedings may be joint investigations or follow other informal processes. Litigated disputes concerning appraisal sometimes involve the proper scope of the appraisal proceeding, because appraisers determine only questions of valuation and not questions of “coverage,” Merrimack Mut. Fire Ins. Co. v. Batts, 59 S.W.3d 142 (Tenn. Ct. App. 2001). Within its scope, an appraisal generally is considered to be a final determination of whatever was decided, e.g., Jupiter Aluminum Corp. v. Home Ins. Co., 225 F.3d 868 (7th Cir. 2000), though the "coverage" issues and bad-faith issues may remain. See Darlow v. Farmers Ins. Exch., 822 P.2d 820 (Wyo. 1991).

Some disputes involve whether the appraisal provision has been waived by one side’s dilatoriness in invoking it, J. Wise Smith & Assoc. v. Nationwide Mut. Ins. Co., 925 F. Supp. 528 (W.D. Tenn. 1995), or whether the policyholder invoked appraisal too soon, which was the conclusion of the North Carolina Court of Appeal recently in Hailey v. Auto-Owners Ins. Co. (N.C. App. Feb. 20, 2007). In Hailey, although the policyholder disagreed with the insurer’s valuation and although the insurance company rebuffed commencing an appraisal proceeding – fighting the matter at both the trial court and later on appeal for more than two years – the court held that the policyholder “prematurely invoked appraisal,” since the disagreement between the policyholder and the insurer was only “unilateral” [sic?]. Slip op. at 13. As the court stated, “[w]e hold that the unsupported opinion of the insured that the insurer’s payment was insufficient does not rise to the level of a disagreement necessary to invoke appraisal,” id. at 13-14, even though the carrier offered no more money, issued a blanket denial of coverage for part of the claim, and repudiated any further steps toward appointment of an appraiser! (A more sensible result might have altered the insured's right to obtain prejudgment interest, or its calculation, from the insurer on the ground that the insured failed to fully perfect its right to pursue appraisal. e.g., Airies Ins. Co. v. Hercas Corp., 781 So.2d 429 (Fla. Dist. App. 2001).)

Another type of dispute concerning appraisers centers on whether the appraiser or the umpire met the requirements of the qualifications clause in the policy or was otherwise an inappropriate appraiser (or umpire) for the dispute. It was this last type of dispute – over the appraiser himself – that confronted the Florida Court of Appeals in Citizens Property Ins. Corp. v. M.A. & F.H. Properties, Ltd (Fla. App. Feb. 21, 2007). In this case, after the insurance company tendered an amount approximating one-third of what the policyholder thought it was owed, the policyholder demanded an appraisal. The homeowner-selected appraiser, Mr. Pellet, determined the amount of loss to be nearly $800,000 (three times the amount offered by the carrier). An umpire was appointed, who sided with the homeowner-selected appraiser.

The insurer sought to vacate the award on the ground that Mr. Pellet was inappropriate to serve as an appraiser, for though he had conducted some 1800 appraisals and written articles in the field, the insurer contended that he was unduly biased against it. No doubt he was biased:

1. Pellet was compensated in the case based on the amount of money the policyholder collected from the insurer.

2. Pellet seems to have developed a bit of a personal animus against the insurer-selected appraiser and, as will be seen, with the insurer. Pellet sent a letter to the other appraiser reading in part:

“This letter is to inform you that you are expressly prohibited from telephonic contact with my office. ALL COMMUNICTAIONS SHALL BE REDUCED to writing . . . . All matters involving appraisal assignments will result in Court ordered umpire. I have zero intentions of discussing any negotiations, settlement, scope or unit costs with you EVER! . . . . Is there any part of this you are unclear about?”

3. Moreover, Pellet had his own personal lawsuit against the insurance company pending before the appraisal at issue, in which he was represented by the same attorney who represented the homeowner in the present case.

Finding that Pellet has “unquestionable personal bias” against the insurer, the Court of Appeal however rejected the challenge to his suitability to serve. The insurance policy’s qualifications clause (that is, the clause that identifies the characteristics of a suitable appraiser) required the appraiser to be “competent.” Compare Auto-Owners Ins. Co. v. Allied Adjusters & Appraisers, Inc., 605 N.W.2d 685 (Mich. App. 1999). (Indeed, other than following the terms of the appraisal clause, the insured is free to select someone who otherwise competent in the matter to serve as the party-appointed appraiser, even a lawyer. Glen Falls Ins. Co. v. Garner, 155 So. 533 (Ala. 1934).) The Florida Court found that Pellet had prior experience and expertise, and that “competence is not synonymous with neutrality or independence.”

Note that one difference between the Florida and North Carolina cases decided one day apart is that in Florida it was the appraiser who said that he would never negotiate with the insurer and instead would automatically seek appointment of an umpire, whereas in the North Carolina case it was the policyholder who sought to initiate appraisal without negotiating preliminarily with the carrier (even though the carrier had issued a blanket denial for at least part of the claim). Notwithstanding that neither law nor equity requires the insured perform idle acts, Cal. Civ. Code § 3532, prudence might dictate that the policyholder go a bit through the motions to satisfy the court that it has given the insurer a last clear chance to make good on its obligations to pay before the policyholder seeks appointment of appraisers.

* * * *

See generally Jonathan Wilkofsky, The Law and Procedure of Insurance Appraisal (Ditmas Park Legal Pub. 2003); Janet Brown and Michael Scroder, Appraisal, Federal of Defense & Corporate Counsel Q.303 (2003).

Posted by Marc Mayerson at 11:51 PM | Comments (7) | TrackBack

Appraising Appraisers and Appraisals

In many property-insurance policies, a party has a right to demand an appraisal, which is procedure in which the value of lost or damaged property is determined. Typically, an appraisal takes the form of what I call a 1 + 1 + 1 structure – each party appoints its own appraiser, and if the two party-appointed appraisers cannot agree on a number the two together then select an umpire (or a court will select an umpire to decide if the two cannot agree on one). That some form of alternative dispute resolution is used for valuation, however, does not mean that there is no room for judicial intervention in disputes involving insurance policies with appraisal provisions.

As with other forms of ADR, courts say they seek to minimize on review their own scrutiny of appraisal process and outcomes. E.g., Emmons v. Lake States Ins. Co., 284 N.W.2d 712 (Mich. App. 1992). Appraisal proceedings may be joint investigations or follow other informal processes. Litigated disputes concerning appraisal sometimes involve the proper scope of the appraisal proceeding, because appraisers determine only questions of valuation and not questions of “coverage,” Merrimack Mut. Fire Ins. Co. v. Batts, 59 S.W.3d 142 (Tenn. Ct. App. 2001). Within its scope, an appraisal generally is considered to be a final determination of whatever was decided, e.g., Jupiter Aluminum Corp. v. Home Ins. Co., 225 F.3d 868 (7th Cir. 2000), though the "coverage" issues and bad-faith issues may remain. See Darlow v. Farmers Ins. Exch., 822 P.2d 820 (Wyo. 1991).

Some disputes involve whether the appraisal provision has been waived by one side’s dilatoriness in invoking it, J. Wise Smith & Assoc. v. Nationwide Mut. Ins. Co., 925 F. Supp. 528 (W.D. Tenn. 1995), or whether the policyholder invoked appraisal too soon, which was the conclusion of the North Carolina Court of Appeal recently in Hailey v. Auto-Owners Ins. Co. (N.C. App. Feb. 20, 2007). In Hailey, although the policyholder disagreed with the insurer’s valuation and although the insurance company rebuffed commencing an appraisal proceeding – fighting the matter at both the trial court and later on appeal for more than two years – the court held that the policyholder “prematurely invoked appraisal,” since the disagreement between the policyholder and the insurer was only “unilateral” [sic?]. Slip op. at 13. As the court stated, “[w]e hold that the unsupported opinion of the insured that the insurer’s payment was insufficient does not rise to the level of a disagreement necessary to invoke appraisal,” id. at 13-14, even though the carrier offered no more money, issued a blanket denial of coverage for part of the claim, and repudiated any further steps toward appointment of an appraiser! (A more sensible result might have altered the insured's right to obtain prejudgment interest, or its calculation, from the insurer on the ground that the insured failed to fully perfect its right to pursue appraisal. e.g., Airies Ins. Co. v. Hercas Corp., 781 So.2d 429 (Fla. Dist. App. 2001).)

Another type of dispute concerning appraisers centers on whether the appraiser or the umpire met the requirements of the qualifications clause in the policy or was otherwise an inappropriate appraiser (or umpire) for the dispute. It was this last type of dispute – over the appraiser himself – that confronted the Florida Court of Appeals in Citizens Property Ins. Corp. v. M.A. & F.H. Properties, Ltd (Fla. App. Feb. 21, 2007). In this case, after the insurance company tendered an amount approximating one-third of what the policyholder thought it was owed, the policyholder demanded an appraisal. The homeowner-selected appraiser, Mr. Pellet, determined the amount of loss to be nearly $800,000 (three times the amount offered by the carrier). An umpire was appointed, who sided with the homeowner-selected appraiser.

The insurer sought to vacate the award on the ground that Mr. Pellet was inappropriate to serve as an appraiser, for though he had conducted some 1800 appraisals and written articles in the field, the insurer contended that he was unduly biased against it. No doubt he was biased:

1. Pellet was compensated in the case based on the amount of money the policyholder collected from the insurer.

2. Pellet seems to have developed a bit of a personal animus against the insurer-selected appraiser and, as will be seen, with the insurer. Pellet sent a letter to the other appraiser reading in part:

“This letter is to inform you that you are expressly prohibited from telephonic contact with my office. ALL COMMUNICTAIONS SHALL BE REDUCED to writing . . . . All matters involving appraisal assignments will result in Court ordered umpire. I have zero intentions of discussing any negotiations, settlement, scope or unit costs with you EVER! . . . . Is there any part of this you are unclear about?”

3. Moreover, Pellet had his own personal lawsuit against the insurance company pending before the appraisal at issue, in which he was represented by the same attorney who represented the homeowner in the present case.

Finding that Pellet has “unquestionable personal bias” against the insurer, the Court of Appeal however rejected the challenge to his suitability to serve. The insurance policy’s qualifications clause (that is, the clause that identifies the characteristics of a suitable appraiser) required the appraiser to be “competent.” Compare Auto-Owners Ins. Co. v. Allied Adjusters & Appraisers, Inc., 605 N.W.2d 685 (Mich. App. 1999). (Indeed, other than following the terms of the appraisal clause, the insured is free to select someone who otherwise competent in the matter to serve as the party-appointed appraiser, even a lawyer. Glen Falls Ins. Co. v. Garner, 155 So. 533 (Ala. 1934).) The Florida Court found that Pellet had prior experience and expertise, and that “competence is not synonymous with neutrality or independence.”

Note that one difference between the Florida and North Carolina cases decided one day apart is that in Florida it was the appraiser who said that he would never negotiate with the insurer and instead would automatically seek appointment of an umpire, whereas in the North Carolina case it was the policyholder who sought to initiate appraisal without negotiating preliminarily with the carrier (even though the carrier had issued a blanket denial for at least part of the claim). Notwithstanding that neither law nor equity requires the insured perform idle acts, Cal. Civ. Code § 3532, prudence might dictate that the policyholder go a bit through the motions to satisfy the court that it has given the insurer a last clear chance to make good on its obligations to pay before the policyholder seeks appointment of appraisers.

* * * *

See generally Jonathan Wilkofsky, The Law and Procedure of Insurance Appraisal (Ditmas Park Legal Pub. 2003); Janet Brown and Michael Scroder, Appraisal, Federal of Defense & Corporate Counsel Q.303 (2003).

Posted by Marc Mayerson at 11:51 PM | Comments (7) | TrackBack

April 5, 2006

What You See Is Not What You Get: Renewal Policies

One aspect of insurance practice that I like is the seemingly unlimited number of nooks and crannies in insurance law. But like a tree falling in the forest, the existence of one pro-policyholder rule or another in a given state has little impact on human behavior -- or trial outcomes -- unless that rule is called upon.  One such rule is the "renewal rule."

When a policyholder renews an insurance policy with its carrier, the insurer must provide prior notice to the insured if it intends to reduce coverage under the newly issued policy. In one of my cases, a corporate client had purchased a primary-layer CGL policy from one insurer in 1969, renewed it in 1970, and then renewed it again. The sudden-and-accidental pollution exclusion was introduced in early 1970 (see Mayerson, Affording Coverage for Gradual Property Damage Under Standard Liability Insurance Policies: A History, 8 Coverage 3 (Sept./Oct. 1998)), so for the final policy the insurer issued its then-standard CGL form and stapled to it the pollution exclusion. The question presented was whether the pollution exclusion in this last policy -- which had been provided to the policyholder, a large multinational chemical company -- was to be given effect.

For a first policy with an insured, the insurer does not have the same duty to point out a limitation on the coverage. Generally speaking, insureds are charged with knowledge of the content of their insurance policies, even if it is undisputed that the insured never actually read the policy at the time it was issued. See generally Western World Ins. Co. v. Stack Oil. Co., 922 F.2d 118, 122 (2d Cir. 1990); Metzger v. Aetna Ins. Co.,, 125 N.E. 814, 816 (N.Y. 1920). (By the way, did you read the insurance policy issued to you before completing the purchase?) But this general rule that insureds are charged with knowledge of the terms of their policies does not overcome the application of the more particular rule regarding renewal of insurance policies. If this were not so, then the well-established notice-of-reduction rule would be without effect. See Davis v. USAA, 273 Cal. Rptr .224, 227 (1990); Magness Constr. Co. v. Ohio Farmers Ins. Co., 261 A.2d 537, 539 (Del. Super. 1969); Walton v. Sterling Fire Ins. Co., 197 N.Y.S.2d 277, 280 (N.Y. App. 1960) ("Implicit in such renewal is that the terms of the existing policy are to be contained in he absence of a contrary intention.").

The renewal rule is not a matter of reformation, see 91 ALR 2d 546, 549 & n.10, or fraud in the factum, and is not subject to a contractual limitations period. The insured may defend against the effort to enforce a coverage-reduction in a renewal policy without pleading and proving the elements of reformation; instead, the (purported) coverage reduction is of no effect. The insurer must prove that in renewal it gave notice before the policy took effect of the desired coverage restriction (and it is not enough for the insurer to send along a notice enclosed with a copy of the renewal -- the insured must be given the opportunity ex ante to object to its inclusion, negotiate its elimination, or take its business elsewhere).

Insureds are under no obligation to disabuse the carrier of a belief that its limitation or exclusion was effective. There is no authority of which I am aware that holds that, when a carrier attempts to reduce coverage in a renewal policy without notice, the insured can be prevented from objecting to enforcement of the unauthorized reduction. Otherwise, an insured would be required to be forever vigilant, guarding against the risk that its carrier might slip an unannounced new exclusion into the renewed policy.

In the case I handled mentioned above, we were litigating the question more than two decades later (the 20-year-old policy nevertheless having been triggered), and no peep was ever made by the insured or its broker at the time. No matter, though. Neither contemporaneous objection nor (detrimental) reliance by the insured is an element of this legal doctrine. In my case, because in the renewal process the insurer did not provide specific advance notice of the reduction in coverage the court had little trouble in concluding that the exclusion -- physically a part of the policy -- was of no legal effect.

Given the state of the law, the outcome we obtained was hardly surprising (to me at least, I'm not so sure about how the insurer thought about it). A more difficult question was presented in a Sixth Circuit case decided in 2003 where a follow-form excess insurer sought to rely on a coverage restriction that was included in the underlying policy, which in turn was a renewal. See Amway Distributors Benefits Ass'n v. Northfield Ins. Co. (6th Cir. 2003). By way of definition, a following-form insurer issues a couple-page policy that principally adopts the terms of the underlying wording and incorporates it as its own. Coca-Cola Bottling Co. v. Columbia Cas. Ins. Co., 11 CA 4th 1176,1182-83, 14 Cal. Rptr. 2d 643, 647 (1992) ("Following form policies 'are typically written on the same terms and conditions as the coverage provided by the underlying primary coverage. They are generally short, consisting of one or two pages, with an endorsement or provision that incorporates by reference the underlying policy coverages, except for the premium, the liability limits, and the obligation to investigate, defend, or pay costs of defense'."); Monsanto Co. v. American Centennial Ins. Co., 1991 WL 35714 (Del. Super. Ct. Feb. 20, 1991); Ford Motor Co. v. Northbrook Ins. Co., 838 F.2d 828 (9th Cir. 1988); following-form carriers may add additional terms and coverage restrictions per other endorsements in the policies they issue. See Home Ins. Co. v. American Home Products, 902 F.2d 1111, 1113 (2d Cir. 1990).

In Amway, here's how the court framed the dispute:

The real question, then, is whether an excess carrier . . . is bound as a matter of law by the underlying carrier's failure to comply with the renewal rule. We believe that the answer is "yes," because the "follow form" linkage between an excess insurer and the primary insurer should logically apply to procedural as well as substantive obligations to their common insured. In effect, an excess insurer who lives by the sword must die by the sword.

Id. The majority rejected the insurer's implicit argument that the insured's position was really the invention of its lawyers and that the coverage -- which would otherwise be barred for the particular claims being fought over -- were not all that important to the insured at the time it bought the policy. Seeming to the relish being confronted with this unusual insurance-law rule, the court states:

This type of extra-contractual argument, if successful, would require those purchasing insurance to affirmatively validate the importance of each and every coverage purchased. We find no authority supporting such an obligation. Furthermore, we suspect that any such obligation would turn the world of insurance upside down, since one has to be either super-diligent or a masochist to read an insurance policy with a fine-toothed comb.

Id. Furthermore, the Sixth Circuit rejected the argument that the presence of a broker as an intermediary on behalf of the insured negates application of the renewal rule. See id. (Kennedy, J., dissenting) ("Where brokers are involved in negotiating the terms of the policy, the rationale for a 'renewal rule' such as Michigan's is diminished, since there would be less need to protect unknowing insureds from the passive misrepresentations of their insurers."). The rejection of the insurer's argument that the renewal rule does not apply if a broker is involved means that just because the insured and its agents are "sophisticated" or possess "bargaining power" does not negative application of the rule, nor is it relevant that the brokers may know (as in the case I handled) that the new exclusionary language was "in the air" as it were, being discussed in trade publications, speeches, industry-form-drafting-organization [now, ISO] press releases, and other vectors of inculcation.

Both the majority and the dissent agreed further that, if an excess insurer was to be bound by the misdeeds of the primary that failed to provide notice of the reduction in coverage, the excess insurer would have recourse against the primary. As the court explained,

This triangular relationship between the primary insurer, the excess insurer, and the insured presents the classic problem of which one of the two relatively "innocent" parties must suffer when the "wrongdoer" causes a loss. IN the present situation, we believe that . . . the excess insurer ] was in a much better position than the insureds to analyze unannounced changes in the underlying policy that it had agreed to follow. As between [the excess insurer] and the insureds, therefore, [the excess insurer] should be bound to provide the greater coverage and be the one to seek indemnity back against the [primary].

This assumption -- which serves as what I tend to call an existential escape valve for the court -- may not be so straightforward; the question whether a primary insurer owes any legal duties directly to excess insurers and the theory under which such a claim is pursued is highly controverted, with much of the judicial commentary falling into obiter dicta rather than ratio decidendi. The nature of the duty and its limits may not be so clear. E.g., Continental Casualty Co. v. Reserve Ins. Co., 307 Minn. 5,10 239 N.W. 2d 862,865 (1976); Certain Underwriters at Lloyd's v. The Fidelity and Casualty Ins. Co. of N.Y., 4 F.3d 541, 547 (7th Cir. 1993). One can imagine such an action being pursued as an equitable contribution or indemnity claim by the excess insurer, but I have not puzzled through how that outcome would be resolved in a well-presented case by both sides. (In turn, the tagged excess or primary might make an claim under its insurance company professional-liability or errors-and-omissions (E&O) coverage or its reinsurance under, in particular, a follow-the-fortunes clause (and then be greeted with negligent underwriting claims as in Bonner v. Cox., known as the Aon 77 case).)

The focus here, of course, from the perspective of the policyholder lawyer, is the renewal doctrine, or the rule that in renewal policies that coverage restrictions are not effective if the insured had no prior notice from the insurer itself of their inclusion. In the case I handled, a chemical company presented with a standard-form CGL policy in 1970 that had a pollution exclusion included. That exclusion was "accepted" by the broker and the insured without objection -- no one ever pointed out any error or confusion about the terms of the coverage. Yet, two different courts looked at the same facts (why two courts is a different story) and each concluded independently that the renewal rule unquestionably applied, and so a primary policy with defense (in additional to limits) coverage was found to apply to several major environmental-liability, site clean-up, natural-resources damages, and toxic-tort administrative and court proceedings, liabilities the carrier would have skated out of (it claimed) if this particular exclusion applied. What we saw -- what both sides saw -- in the file as the actual, bona fide copy of the policy was indeed what we ended up with -- sans an outcome-determinative exclusion.

While the notice-of-reduction-in-a-renewal-policy rule is a favorable one that policyholders should press when presenting or litigating claims against their insurance company, it cannot do so unless the policyholder's counsel is aware of this particular rule; if not, then the insured's lawyer better be an insured lawyer.

Tags: Insurance, Blawg, Renewal Policy, Reduction in Renewal Policy, New Exclusions, Insurance Litigation, Insurance Coverage, Policyholder Lawyer

Posted by Marc Mayerson at 12:11 AM | Comments (3) | TrackBack

What You See Is Not What You Get: Renewal Policies

One aspect of insurance practice that I like is the seemingly unlimited number of nooks and crannies in insurance law. But like a tree falling in the forest, the existence of one pro-policyholder rule or another in a given state has little impact on human behavior -- or trial outcomes -- unless that rule is called upon.  One such rule is the "renewal rule."

When a policyholder renews an insurance policy with its carrier, the insurer must provide prior notice to the insured if it intends to reduce coverage under the newly issued policy. In one of my cases, a corporate client had purchased a primary-layer CGL policy from one insurer in 1969, renewed it in 1970, and then renewed it again. The sudden-and-accidental pollution exclusion was introduced in early 1970 (see Mayerson, Affording Coverage for Gradual Property Damage Under Standard Liability Insurance Policies: A History, 8 Coverage 3 (Sept./Oct. 1998)), so for the final policy the insurer issued its then-standard CGL form and stapled to it the pollution exclusion. The question presented was whether the pollution exclusion in this last policy -- which had been provided to the policyholder, a large multinational chemical company -- was to be given effect.

For a first policy with an insured, the insurer does not have the same duty to point out a limitation on the coverage. Generally speaking, insureds are charged with knowledge of the content of their insurance policies, even if it is undisputed that the insured never actually read the policy at the time it was issued. See generally Western World Ins. Co. v. Stack Oil. Co., 922 F.2d 118, 122 (2d Cir. 1990); Metzger v. Aetna Ins. Co.,, 125 N.E. 814, 816 (N.Y. 1920). (By the way, did you read the insurance policy issued to you before completing the purchase?) But this general rule that insureds are charged with knowledge of the terms of their policies does not overcome the application of the more particular rule regarding renewal of insurance policies. If this were not so, then the well-established notice-of-reduction rule would be without effect. See Davis v. USAA, 273 Cal. Rptr .224, 227 (1990); Magness Constr. Co. v. Ohio Farmers Ins. Co., 261 A.2d 537, 539 (Del. Super. 1969); Walton v. Sterling Fire Ins. Co., 197 N.Y.S.2d 277, 280 (N.Y. App. 1960) ("Implicit in such renewal is that the terms of the existing policy are to be contained in he absence of a contrary intention.").

The renewal rule is not a matter of reformation, see 91 ALR 2d 546, 549 & n.10, or fraud in the factum, and is not subject to a contractual limitations period. The insured may defend against the effort to enforce a coverage-reduction in a renewal policy without pleading and proving the elements of reformation; instead, the (purported) coverage reduction is of no effect. The insurer must prove that in renewal it gave notice before the policy took effect of the desired coverage restriction (and it is not enough for the insurer to send along a notice enclosed with a copy of the renewal -- the insured must be given the opportunity ex ante to object to its inclusion, negotiate its elimination, or take its business elsewhere).

Insureds are under no obligation to disabuse the carrier of a belief that its limitation or exclusion was effective. There is no authority of which I am aware that holds that, when a carrier attempts to reduce coverage in a renewal policy without notice, the insured can be prevented from objecting to enforcement of the unauthorized reduction. Otherwise, an insured would be required to be forever vigilant, guarding against the risk that its carrier might slip an unannounced new exclusion into the renewed policy.

In the case I handled mentioned above, we were litigating the question more than two decades later (the 20-year-old policy nevertheless having been triggered), and no peep was ever made by the insured or its broker at the time. No matter, though. Neither contemporaneous objection nor (detrimental) reliance by the insured is an element of this legal doctrine. In my case, because in the renewal process the insurer did not provide specific advance notice of the reduction in coverage the court had little trouble in concluding that the exclusion -- physically a part of the policy -- was of no legal effect.

Given the state of the law, the outcome we obtained was hardly surprising (to me at least, I'm not so sure about how the insurer thought about it). A more difficult question was presented in a Sixth Circuit case decided in 2003 where a follow-form excess insurer sought to rely on a coverage restriction that was included in the underlying policy, which in turn was a renewal. See Amway Distributors Benefits Ass'n v. Northfield Ins. Co. (6th Cir. 2003). By way of definition, a following-form insurer issues a couple-page policy that principally adopts the terms of the underlying wording and incorporates it as its own. Coca-Cola Bottling Co. v. Columbia Cas. Ins. Co., 11 CA 4th 1176,1182-83, 14 Cal. Rptr. 2d 643, 647 (1992) ("Following form policies 'are typically written on the same terms and conditions as the coverage provided by the underlying primary coverage. They are generally short, consisting of one or two pages, with an endorsement or provision that incorporates by reference the underlying policy coverages, except for the premium, the liability limits, and the obligation to investigate, defend, or pay costs of defense'."); Monsanto Co. v. American Centennial Ins. Co., 1991 WL 35714 (Del. Super. Ct. Feb. 20, 1991); Ford Motor Co. v. Northbrook Ins. Co., 838 F.2d 828 (9th Cir. 1988); following-form carriers may add additional terms and coverage restrictions per other endorsements in the policies they issue. See Home Ins. Co. v. American Home Products, 902 F.2d 1111, 1113 (2d Cir. 1990).

In Amway, here's how the court framed the dispute:

The real question, then, is whether an excess carrier . . . is bound as a matter of law by the underlying carrier's failure to comply with the renewal rule. We believe that the answer is "yes," because the "follow form" linkage between an excess insurer and the primary insurer should logically apply to procedural as well as substantive obligations to their common insured. In effect, an excess insurer who lives by the sword must die by the sword.

Id. The majority rejected the insurer's implicit argument that the insured's position was really the invention of its lawyers and that the coverage -- which would otherwise be barred for the particular claims being fought over -- were not all that important to the insured at the time it bought the policy. Seeming to the relish being confronted with this unusual insurance-law rule, the court states:

This type of extra-contractual argument, if successful, would require those purchasing insurance to affirmatively validate the importance of each and every coverage purchased. We find no authority supporting such an obligation. Furthermore, we suspect that any such obligation would turn the world of insurance upside down, since one has to be either super-diligent or a masochist to read an insurance policy with a fine-toothed comb.

Id. Furthermore, the Sixth Circuit rejected the argument that the presence of a broker as an intermediary on behalf of the insured negates application of the renewal rule. See id. (Kennedy, J., dissenting) ("Where brokers are involved in negotiating the terms of the policy, the rationale for a 'renewal rule' such as Michigan's is diminished, since there would be less need to protect unknowing insureds from the passive misrepresentations of their insurers."). The rejection of the insurer's argument that the renewal rule does not apply if a broker is involved means that just because the insured and its agents are "sophisticated" or possess "bargaining power" does not negative application of the rule, nor is it relevant that the brokers may know (as in the case I handled) that the new exclusionary language was "in the air" as it were, being discussed in trade publications, speeches, industry-form-drafting-organization [now, ISO] press releases, and other vectors of inculcation.

Both the majority and the dissent agreed further that, if an excess insurer was to be bound by the misdeeds of the primary that failed to provide notice of the reduction in coverage, the excess insurer would have recourse against the primary. As the court explained,

This triangular relationship between the primary insurer, the excess insurer, and the insured presents the classic problem of which one of the two relatively "innocent" parties must suffer when the "wrongdoer" causes a loss. IN the present situation, we believe that . . . the excess insurer ] was in a much better position than the insureds to analyze unannounced changes in the underlying policy that it had agreed to follow. As between [the excess insurer] and the insureds, therefore, [the excess insurer] should be bound to provide the greater coverage and be the one to seek indemnity back against the [primary].

This assumption -- which serves as what I tend to call an existential escape valve for the court -- may not be so straightforward; the question whether a primary insurer owes any legal duties directly to excess insurers and the theory under which such a claim is pursued is highly controverted, with much of the judicial commentary falling into obiter dicta rather than ratio decidendi. The nature of the duty and its limits may not be so clear. E.g., Continental Casualty Co. v. Reserve Ins. Co., 307 Minn. 5,10 239 N.W. 2d 862,865 (1976); Certain Underwriters at Lloyd's v. The Fidelity and Casualty Ins. Co. of N.Y., 4 F.3d 541, 547 (7th Cir. 1993). One can imagine such an action being pursued as an equitable contribution or indemnity claim by the excess insurer, but I have not puzzled through how that outcome would be resolved in a well-presented case by both sides. (In turn, the tagged excess or primary might make an claim under its insurance company professional-liability or errors-and-omissions (E&O) coverage or its reinsurance under, in particular, a follow-the-fortunes clause (and then be greeted with negligent underwriting claims as in Bonner v. Cox., known as the Aon 77 case).)

The focus here, of course, from the perspective of the policyholder lawyer, is the renewal doctrine, or the rule that in renewal policies that coverage restrictions are not effective if the insured had no prior notice from the insurer itself of their inclusion. In the case I handled, a chemical company presented with a standard-form CGL policy in 1970 that had a pollution exclusion included. That exclusion was "accepted" by the broker and the insured without objection -- no one ever pointed out any error or confusion about the terms of the coverage. Yet, two different courts looked at the same facts (why two courts is a different story) and each concluded independently that the renewal rule unquestionably applied, and so a primary policy with defense (in additional to limits) coverage was found to apply to several major environmental-liability, site clean-up, natural-resources damages, and toxic-tort administrative and court proceedings, liabilities the carrier would have skated out of (it claimed) if this particular exclusion applied. What we saw -- what both sides saw -- in the file as the actual, bona fide copy of the policy was indeed what we ended up with -- sans an outcome-determinative exclusion.

While the notice-of-reduction-in-a-renewal-policy rule is a favorable one that policyholders should press when presenting or litigating claims against their insurance company, it cannot do so unless the policyholder's counsel is aware of this particular rule; if not, then the insured's lawyer better be an insured lawyer.

Tags: Insurance, Blawg, Renewal Policy, Reduction in Renewal Policy, New Exclusions, Insurance Litigation, Insurance Coverage, Policyholder Lawyer

Posted by Marc Mayerson at 12:11 AM | Comments (3) | TrackBack

February 28, 2006

Entwining Physical and Economic Losses under Business-Interruption Insurance

In his seminal book published more than 75 years ago entitled Business Interruption Insurance (Philadelphia 1930), C.M. Kahler wrote that “[u]nfortunately the development of an adequate system of business interruption insurance has been hampered by the fact that it has always been considered as a part of the direct damage insurance of the particular hazard.” Had United Airlines heeded Kahler’s insights into the nature of business-interruption coverage it could have structured its policy coverage to position itself better for recovery from its 9/11 losses; instead, United Airlines litigated a case that it lost at the trial court level and lost again on appeal to the Second Circuit. United Air Lines, Inc. v. Insurance Co. of the State of PA (2d Cir. Feb. 22, 2006).

It is crucial that policyholders understand that business-interruption insurance is fundamentally tethered to an antecedent physical property loss. Consequently, one sees litigation, as with the Chicago flood more than a decade ago, where tenants on the upper floors of a building were denied coverage because only the building’s lobby was flooded, impeding access to their property, and no physical loss occurred to their own property as to qualify them for business-interruption coverage.

Because of this relationship between physical loss and the business-interruption or business-income insurance recovery, policyholders seek to expand the triggers of the coverage to include circumstances that do not cause physical damage to their own property interests. As a result, policyholders will purchase coverage-trigger enhancements such that their policies apply if there is interference with “ingress-egress” to their property or if the suspension of operations results from the action of public authorities.

The key is to understand that because the paradigm of business-interruption cover is tied to a physical loss, so if the policyholder wishes to obtain coverage more broadly – something that may be quite advisable – it must take care to ensure that the contract is clear on this point.

United Air Lines may have thought that it had done that, but at least in the language quoted by the courts it failed (one might now expect a suit against its broker). Two years after the 9/11 attacks, United Airlines brought suit under its $25 million “Property Terrorism & Sabotage” insurance policy, seeking coverage for its losses associated with its former facility in the World Trade Center as well as for losses associated with its facilities at Ronald Reagan Washington National Airport. To the extent United needed to tether its Washington-area claim to a physical-damage loss it sought to do so based on the proximity of the Pentagon to the airport.

United argued that the policy broadly covered losses due to the government’s shutdown of the air-traffic system following 9/11. United focused on trigger – what must happen during the policy period for the policy to potentially apply – while effacing and hence eliding the valuation provision that calculates what, if anything, is owed in the event of a loss triggering the coverage. (As will be seen, the valuation provision took away what (arguably) the trigger provision gave.)

The policy covered business interruption that resulted from Terrorism and “any ensuing fire damage, damage from looting, or other damage caused by an act of a lawfully constituted authority for the purpose of suppressing or minimizing the consequences of [a terrorism] incident[].” United argued this language provided coverage for “Suppression Damages” up to the policy limit for loss of gross earnings. While the face of this language would seem to focus on “damage” – a category different from “loss of gross earnings” -- and thus negate United’s argument (but the court sort of accepted arguendo the assumption of coverage), the Second Circuit held against United on the ground that the policy set forth how one calculates covered “loss of gross earnings” and that within that provision there was a codicil limiting recoverable amounts to those stemming from damage to an “adjacent property.”

In other words, the policy did not cover loss of gross earnings in general but rather only a limited subset of that type of loss tethered to some physical damage to an adjacent property. Or put somewhat different, the court looks less to what is covered in the abstract but rather focuses more pragmatically on the concrete conduct required by each party and what can be compelled against an unwilling other failing to live up the language of the bargain it signed. (United might well have had argument that the valuation language was too buried in the fine print to overcome the thrust of the insuring agreement, Haynes v. Farmers Ins. Exch., 32 Cal. 4th 1198 (2004), but such arguments often face uphill sledding when run by companies the size of United.) The “Valuation” section and its specification of indemnifiable “gross earnings” instantiated and made manifest the scope of the coverage promised in the insuring agreement. In other words, what gummed up United was not that the loss it suffered did not result from suppression damages from terrorism so much as that the indemnifiable loss it suffered was controlled by the valuation provision and assayed thereunder to be zero.

Given the wording of the valuation provision, “in order for [the insurer] to have a duty to indemnify United for lost earnings, the government action in question must either have physically damaged United’s property or been caused by physical damage to adjacent property.” (Slip op. at 12) This construction is based on the policy language stating that gross-earnings coverage “is specially extended to cover a situation when access to the Insured Locations [the airport] is prohibited by order of civil authority as a direct result of damage to adjacent premises.” In other words, even though “suppression damages” are covered, they are measured only by gross-earnings loss stemming from either direct-damage or damage to adjacent facilities.

The Second Circuit held that the Pentagon was not “adjacent” to United’s facility with the Washington, D.C. airport, which certainly comports with the facts on the ground. As the court earlier concludes, “[t]here is, in sum, no validity to United’s argument that there arises under [the insuring agreement] a duty for [the insurer] to indemnify United for any and all damages of any kind whatsoever that result from the government’s efforts to suppress terrorism.” (Slip op. at 13)

The United case is consistent with the deep presumptions governing business-interruption coverage for the past 75 years since Kahler’s study. First, the insured needs to possess some “insurable interest” in the subject property whose interruption in operations is insured. See Zurich American Ins. Co. v. ABM Industries, Inc., 397 F.3d 158 (2d Cir. 2005); Kahler, Business Interruption Insurance, Ch. II; cf., Wal-Mart v. AIG Life (Del. Ch. March 2, 2004). Second, the paradigm supposes some property is physically damaged, whether that property is the insured’s or is that of a supplier or customer whose risk of loss is insured against under “contingent business interruption” coverage. The policy can be expanded beyond physical-damage claims, but care must be taken to ensure that this is true as a matter of both trigger and valuation (measurement of what component of loss is indemnifiable).

Just as the integration of the economy generally makes traditional and contingent business-interruption coverages all the more important, the newly felt risks of loss in the modern era from terrorism and other economically oriented assaults like cybercrimes make broad, non-physically tied losses crucial to insure against too. But given the background principles and biases imbuing the field of business-interruption coverage, policyholders wishing to purchase this form of protection must make it absolutely clear in the policy that the transfer of these types of risks is what it is paying for.

No one doubts that United’s loss here was genuine; there is no moral hazard or risk that the presence of insurance somehow contributed to the amount of loss it suffered. (Cf., Kahler, Ch. II at 2.) The question the Second Circuit confronted was whether United had transferred the risk of loss to its insurer: under the policy language at issue it is fairly clear that United did not do so.

Posted by Marc Mayerson at 11:03 PM | Comments (1) | TrackBack

Entwining Physical and Economic Losses under Business-Interruption Insurance

In his seminal book published more than 75 years ago entitled Business Interruption Insurance (Philadelphia 1930), C.M. Kahler wrote that “[u]nfortunately the development of an adequate system of business interruption insurance has been hampered by the fact that it has always been considered as a part of the direct damage insurance of the particular hazard.” Had United Airlines heeded Kahler’s insights into the nature of business-interruption coverage it could have structured its policy coverage to position itself better for recovery from its 9/11 losses; instead, United Airlines litigated a case that it lost at the trial court level and lost again on appeal to the Second Circuit. United Air Lines, Inc. v. Insurance Co. of the State of PA (2d Cir. Feb. 22, 2006).

It is crucial that policyholders understand that business-interruption insurance is fundamentally tethered to an antecedent physical property loss. Consequently, one sees litigation, as with the Chicago flood more than a decade ago, where tenants on the upper floors of a building were denied coverage because only the building’s lobby was flooded, impeding access to their property, and no physical loss occurred to their own property as to qualify them for business-interruption coverage.

Because of this relationship between physical loss and the business-interruption or business-income insurance recovery, policyholders seek to expand the triggers of the coverage to include circumstances that do not cause physical damage to their own property interests. As a result, policyholders will purchase coverage-trigger enhancements such that their policies apply if there is interference with “ingress-egress” to their property or if the suspension of operations results from the action of public authorities.

The key is to understand that because the paradigm of business-interruption cover is tied to a physical loss, so if the policyholder wishes to obtain coverage more broadly – something that may be quite advisable – it must take care to ensure that the contract is clear on this point.

United Air Lines may have thought that it had done that, but at least in the language quoted by the courts it failed (one might now expect a suit against its broker). Two years after the 9/11 attacks, United Airlines brought suit under its $25 million “Property Terrorism & Sabotage” insurance policy, seeking coverage for its losses associated with its former facility in the World Trade Center as well as for losses associated with its facilities at Ronald Reagan Washington National Airport. To the extent United needed to tether its Washington-area claim to a physical-damage loss it sought to do so based on the proximity of the Pentagon to the airport.

United argued that the policy broadly covered losses due to the government’s shutdown of the air-traffic system following 9/11. United focused on trigger – what must happen during the policy period for the policy to potentially apply – while effacing and hence eliding the valuation provision that calculates what, if anything, is owed in the event of a loss triggering the coverage. (As will be seen, the valuation provision took away what (arguably) the trigger provision gave.)

The policy covered business interruption that resulted from Terrorism and “any ensuing fire damage, damage from looting, or other damage caused by an act of a lawfully constituted authority for the purpose of suppressing or minimizing the consequences of [a terrorism] incident[].” United argued this language provided coverage for “Suppression Damages” up to the policy limit for loss of gross earnings. While the face of this language would seem to focus on “damage” – a category different from “loss of gross earnings” -- and thus negate United’s argument (but the court sort of accepted arguendo the assumption of coverage), the Second Circuit held against United on the ground that the policy set forth how one calculates covered “loss of gross earnings” and that within that provision there was a codicil limiting recoverable amounts to those stemming from damage to an “adjacent property.”

In other words, the policy did not cover loss of gross earnings in general but rather only a limited subset of that type of loss tethered to some physical damage to an adjacent property. Or put somewhat different, the court looks less to what is covered in the abstract but rather focuses more pragmatically on the concrete conduct required by each party and what can be compelled against an unwilling other failing to live up the language of the bargain it signed. (United might well have had argument that the valuation language was too buried in the fine print to overcome the thrust of the insuring agreement, Haynes v. Farmers Ins. Exch., 32 Cal. 4th 1198 (2004), but such arguments often face uphill sledding when run by companies the size of United.) The “Valuation” section and its specification of indemnifiable “gross earnings” instantiated and made manifest the scope of the coverage promised in the insuring agreement. In other words, what gummed up United was not that the loss it suffered did not result from suppression damages from terrorism so much as that the indemnifiable loss it suffered was controlled by the valuation provision and assayed thereunder to be zero.

Given the wording of the valuation provision, “in order for [the insurer] to have a duty to indemnify United for lost earnings, the government action in question must either have physically damaged United’s property or been caused by physical damage to adjacent property.” (Slip op. at 12) This construction is based on the policy language stating that gross-earnings coverage “is specially extended to cover a situation when access to the Insured Locations [the airport] is prohibited by order of civil authority as a direct result of damage to adjacent premises.” In other words, even though “suppression damages” are covered, they are measured only by gross-earnings loss stemming from either direct-damage or damage to adjacent facilities.

The Second Circuit held that the Pentagon was not “adjacent” to United’s facility with the Washington, D.C. airport, which certainly comports with the facts on the ground. As the court earlier concludes, “[t]here is, in sum, no validity to United’s argument that there arises under [the insuring agreement] a duty for [the insurer] to indemnify United for any and all damages of any kind whatsoever that result from the government’s efforts to suppress terrorism.” (Slip op. at 13)

The United case is consistent with the deep presumptions governing business-interruption coverage for the past 75 years since Kahler’s study. First, the insured needs to possess some “insurable interest” in the subject property whose interruption in operations is insured. See Zurich American Ins. Co. v. ABM Industries, Inc., 397 F.3d 158 (2d Cir. 2005); Kahler, Business Interruption Insurance, Ch. II; cf., Wal-Mart v. AIG Life (Del. Ch. March 2, 2004). Second, the paradigm supposes some property is physically damaged, whether that property is the insured’s or is that of a supplier or customer whose risk of loss is insured against under “contingent business interruption” coverage. The policy can be expanded beyond physical-damage claims, but care must be taken to ensure that this is true as a matter of both trigger and valuation (measurement of what component of loss is indemnifiable).

Just as the integration of the economy generally makes traditional and contingent business-interruption coverages all the more important, the newly felt risks of loss in the modern era from terrorism and other economically oriented assaults like cybercrimes make broad, non-physically tied losses crucial to insure against too. But given the background principles and biases imbuing the field of business-interruption coverage, policyholders wishing to purchase this form of protection must make it absolutely clear in the policy that the transfer of these types of risks is what it is paying for.

No one doubts that United’s loss here was genuine; there is no moral hazard or risk that the presence of insurance somehow contributed to the amount of loss it suffered. (Cf., Kahler, Ch. II at 2.) The question the Second Circuit confronted was whether United had transferred the risk of loss to its insurer: under the policy language at issue it is fairly clear that United did not do so.

Posted by Marc Mayerson at 11:03 PM | Comments (1) | TrackBack

November 6, 2005

Insurance for Goods in Transit

Companies that make things need to get those things to their customers, and they face the risk of loss while the goods are in transit to the customer. Via contract, one can shift or retain the risk of loss during transit, such as having title pass to the customer once the item leaves the company’s facility or to wait until the customer accepts the item at its location. In addition to shifting to one party or the other the risk of loss via the sale contract, the company can obtain insurance to protect itself against loss. Recent cases have addressed both liability coverage – insurance against the risk of loss to goods for which title has passed to the buyer – and first-party coverage – insurance against loss in transit while title remains vested in the seller.

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.

Posted by Marc Mayerson at 6:20 PM | Comments (3) | TrackBack

Insurance for Goods in Transit

Companies that make things need to get those things to their customers, and they face the risk of loss while the goods are in transit to the customer. Via contract, one can shift or retain the risk of loss during transit, such as having title pass to the customer once the item leaves the company’s facility or to wait until the customer accepts the item at its location. In addition to shifting to one party or the other the risk of loss via the sale contract, the company can obtain insurance to protect itself against loss. Recent cases have addressed both liability coverage – insurance against the risk of loss to goods for which title has passed to the buyer – and first-party coverage – insurance against loss in transit while title remains vested in the seller.

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.

Posted by Marc Mayerson at 6:20 PM | Comments (3) | TrackBack

September 21, 2005

Katrina -- Submit Your Proofs of Loss or Forfeit Insurance Coverage -- Updated!

The federal government provides flood insurance protection principally through private insurance companies. These flood policies require that the insured file a sworn proof of loss within 60 days from the date of the damage. In the circumstances of Katrina, there has been a great desire to assist policyholders in obtaining their coverage benefits. FEMA apparently has responded by relaxing the period within which to file a claim and, if necessary, to bring suit.

In the past, court have strictly enforced the 60-day deadline within which to file a proof of loss -- i.e., a failure to comply has resulted in a total forfeiture of coverage. Flood victims always are sympathetic plaintiffs, but the courts have not always been responsive. For example, the Eleventh Circuit, in a decision issued three months before Katrina, held that a policyholder forfeited coverage by not submitting the proof of loss within 60 days, even though the insurance adjuster first came to the policyholder's property 90 days after the loss. Lucien v. US Security Ins. Co. (11th Cir. June 8, 2005).

On September 21, 2005, FEMA promulgated guidelines for the adjustment of Katrina-related losses. Moroever, FEMA has authorized payment of claims based on an adjuster's report alone, rather than requiring a separate proof-of-loss submission. If the policyholder does not agree with the adjuster's analysis of the covered loss, the policyholder then must file a proof of loss and that proof of loss must be submitted within twelve months of the date of loss. (Note that the twelve-month period is from the loss date not the date of the adjuster's report.) If the insurer then denies the policyholder's claim based on the proof of loss, the policyholder is required to file its lawsuit within twelve months of the date of claim denial.

This revised process applies to all flood-events between August 23, 2005 and December 31, 2005.

Individuals and businesses that suffered loss from Katrina should not wait until the adjuster comes knocking to put a marker down, that is, even if one is not be in a position to submit the full proof of loss, it is still advisable to submit a partial proof of loss, noting that the entire amount of the loss is not yet determined. Personally, I would not be comfortable in allowing the 60-day period to elapse if I knew I had flood coverage and the adjuster had not yet arrived (as the Lucien case shows). FEMA has a guide to submitting claims, and the insurers have set up a website that seeks to provide comprehensive contact information for flood insurers.

One must be careful that in submitting a claim for flood that one is not undermining a claim under a property or homeowners policy. Accordingly, it is advisable in submitting the proof of loss to the flood program to temporize by stating that "[Policyholder] submits this proof of loss to comply with the requirements of its flood-insurance policy, although it is uncertain at this time the extent to which the items claimed were caused by flood or caused by another hazard covered by other insurance policies."

For the moment, protective claims should be submitted to any possibly available insurance, flood, property, or homeowners.

Posted by Marc Mayerson at 10:20 AM | Comments (11) | TrackBack

Katrina -- Submit Your Proofs of Loss or Forfeit Insurance Coverage -- Updated!

The federal government provides flood insurance protection principally through private insurance companies. These flood policies require that the insured file a sworn proof of loss within 60 days from the date of the damage. In the circumstances of Katrina, there has been a great desire to assist policyholders in obtaining their coverage benefits. FEMA apparently has responded by relaxing the period within which to file a claim and, if necessary, to bring suit.

In the past, court have strictly enforced the 60-day deadline within which to file a proof of loss -- i.e., a failure to comply has resulted in a total forfeiture of coverage. Flood victims always are sympathetic plaintiffs, but the courts have not always been responsive. For example, the Eleventh Circuit, in a decision issued three months before Katrina, held that a policyholder forfeited coverage by not submitting the proof of loss within 60 days, even though the insurance adjuster first came to the policyholder's property 90 days after the loss. Lucien v. US Security Ins. Co. (11th Cir. June 8, 2005).

On September 21, 2005, FEMA promulgated guidelines for the adjustment of Katrina-related losses. Moroever, FEMA has authorized payment of claims based on an adjuster's report alone, rather than requiring a separate proof-of-loss submission. If the policyholder does not agree with the adjuster's analysis of the covered loss, the policyholder then must file a proof of loss and that proof of loss must be submitted within twelve months of the date of loss. (Note that the twelve-month period is from the loss date not the date of the adjuster's report.) If the insurer then denies the policyholder's claim based on the proof of loss, the policyholder is required to file its lawsuit within twelve months of the date of claim denial.

This revised process applies to all flood-events between August 23, 2005 and December 31, 2005.

Individuals and businesses that suffered loss from Katrina should not wait until the adjuster comes knocking to put a marker down, that is, even if one is not be in a position to submit the full proof of loss, it is still advisable to submit a partial proof of loss, noting that the entire amount of the loss is not yet determined. Personally, I would not be comfortable in allowing the 60-day period to elapse if I knew I had flood coverage and the adjuster had not yet arrived (as the Lucien case shows). FEMA has a guide to submitting claims, and the insurers have set up a website that seeks to provide comprehensive contact information for flood insurers.

One must be careful that in submitting a claim for flood that one is not undermining a claim under a property or homeowners policy. Accordingly, it is advisable in submitting the proof of loss to the flood program to temporize by stating that "[Policyholder] submits this proof of loss to comply with the requirements of its flood-insurance policy, although it is uncertain at this time the extent to which the items claimed were caused by flood or caused by another hazard covered by other insurance policies."

For the moment, protective claims should be submitted to any possibly available insurance, flood, property, or homeowners.

Posted by Marc Mayerson at 10:20 AM | Comments (11) | TrackBack

September 6, 2005

Businesses Far from Katrina May Have Insurance Claims

Businesses lucky enough to be located outside of Katrina's wrath still are exposed to losses from the hurricane: while they may not have suffered physical losses to their assets, their suppliers or customers, or both, may have been damaged. As a result, these "unaffected" businesses may have coverage for their own economic losses stemming from Katrina.

An increasingly common add-on to coverage in recent years has been "contingent" business-interruption coverage (or contingent business-income coverage). These policies are limited in what types of event triggers their coverage: typically, only those hazards that are insured against with respect to the insured's own assets qualify as covered events when they befall the insured's supplier or the insured's customer.

In general, there are certain steps that companies should now be taking:

1. Check to see if your property policies include coverage for contingent business-interruption losses (or trade-disruption losses).
2. Give notice NOW to your insurance company of the possibility of a covered loss.
3. Carefully and contemporaneously document the lost sales or increased costs that may be attributable to Katrina. The more contemporaneous documentation, including memorializing memoranda to file, the better in the event of a coverage dispute.
4. Consider engaging counsel, forensic accountants, or a public adjuster to assist you in gathering the financial material needed to prove your claim.
5. Beware that many policies include a time period within which a suit for coverage must be brought or within which notice or proof of loss must be provided. If there is any possibility that the time period is about to expire, ask the insurer for an extension of the period and obtain the insurer's written agreement. It is vastly easier to obtain an extension than to litigate questions of the tolling of the period.

Posted by Marc Mayerson at 3:51 PM | Comments (3)

Businesses Far from Katrina May Have Insurance Claims

Businesses lucky enough to be located outside of Katrina's wrath still are exposed to losses from the hurricane: while they may not have suffered physical losses to their assets, their suppliers or customers, or both, may have been damaged. As a result, these "unaffected" businesses may have coverage for their own economic losses stemming from Katrina.

An increasingly common add-on to coverage in recent years has been "contingent" business-interruption coverage (or contingent business-income coverage). These policies are limited in what types of event triggers their coverage: typically, only those hazards that are insured against with respect to the insured's own assets qualify as covered events when they befall the insured's supplier or the insured's customer.

In general, there are certain steps that companies should now be taking:

1. Check to see if your property policies include coverage for contingent business-interruption losses (or trade-disruption losses).
2. Give notice NOW to your insurance company of the possibility of a covered loss.
3. Carefully and contemporaneously document the lost sales or increased costs that may be attributable to Katrina. The more contemporaneous documentation, including memorializing memoranda to file, the better in the event of a coverage dispute.
4. Consider engaging counsel, forensic accountants, or a public adjuster to assist you in gathering the financial material needed to prove your claim.
5. Beware that many policies include a time period within which a suit for coverage must be brought or within which notice or proof of loss must be provided. If there is any possibility that the time period is about to expire, ask the insurer for an extension of the period and obtain the insurer's written agreement. It is vastly easier to obtain an extension than to litigate questions of the tolling of the period.

Posted by Marc Mayerson at 3:51 PM | Comments (3)

June 27, 2005

Accidental Suicide

Derivative liability for the acts of others is a feature of tort and other liability regimes, and these forms of liability then present insurance-coverage issues in terms of whether the insured seeking coverage is somehow charged with the knowledge of the actor who engaged in the conduct at issue.

Usually, courts properly distinguish between the insured that is seeking contract recovery from the intent of the person whose conduct created the liability visited on the insured derivatively. This question gets played out in jurisdictions that do not afford indemnification for punitive damages, but allow insurance recovery where the punitive damages are imposed vicariously. Unigard Sec. Ins. Co. v. Murphy Oil USA, Inc., 962 S.W.2d 735 (Ark. 1998); US Concrete Pipe Co. v. Bould, 437 So. 2d 1061 (Fla. 1983); Glens Falls Indem. Co. v. Atlantic Building Corp., 199 F.2d 60 (4th Cir. 1952).

One also sees this in the first-party coverage context where the actions of an employee are not accidental – such as in committing arson – but which remain fortuitous from the standpoint of the insured (employer). In this context – or in any circumstance where corporate employees are involved and the corporation itself is seeking coverage – the landmark case is Northern Assur. Co. v. Rachlin Clothes Shop Inc., 125 A. 184, 188 (Del. 1924).

Recently, the West Virginia Supreme Court had occasion to address the unusual fact pattern of a sheriff and county commission seeking coverage for liability claims stemming from the suicides of two inmates in the country jail. Columbia Cas. Co. v. Westfield Ins. Co., No. 31941 (W. Va. June 10, 2005), available at http://www.state.wv.us/wvsca/docs/spring05/31941.pdf . The insurer denied coverage on the ground that the acts leading to the claim were not accidental – i.e., the inmates’ suicides themselves were not an accident or fortuitous event covered by the policy.

On certification from the US Court of Appeals for the Fourth Circuit, the West Virginia court ruled that coverage turned not on whether the acts leading to the liability claims were non-accidental but rather whether they were fortuitous or accidental from the standpoint of the insured seeking coverage. As the court stated: “[W]e hold that in determining whether under a liability insurance policy an occurrence was or was not an ‘accident’ – or was or was not deliberate, intentional, expected, desired or foreseen – primary consideration, relevance, and weight should ordinarily be given to the perspective or standpoint of the insured whose coverage under the policy is at issue.” (Slip op. at 9)

Where the entity – in Columbia Casualty, the county commission, or in corporate policyholder cases, the corporation itself – does not expect or intend the injury alleged (that is, where it did not expect or intend its agent to cause harm in completing his duties, compare Ashland Oil Inc. v. Miller Oil Purchasing Co., 678 F.2d 1293, 1317 (5th Cir. 1982); Travelers Indemnity Co. v. Bloomington Steel Supply Co., 695 N.W.2d 408 (Minn. App. 2005), ascribing the conduct of the harm-causing agent to the entity undermines its purpose in purchasing insurance in the first place: transferring to the insurer the risk of liability for harm or other loss caused by its employees. There is a difference between imposing liability vicariously as a matter of social policy, as in respondeat superior, and enforcing the terms of the insurance contract. Policyholders have the reasonable expectation that coverage will be afforded when loss occurs due to the acts of someone other than the insured seeking coverage.

This is what the Delaware Supreme Court correctly understood four score years ago in Rachlin and what the West Virginia Supreme Court correctly held in Columbia Casualty.

Posted by Marc Mayerson at 6:07 PM | Comments (2) | TrackBack

Accidental Suicide

Derivative liability for the acts of others is a feature of tort and other liability regimes, and these forms of liability then present insurance-coverage issues in terms of whether the insured seeking coverage is somehow charged with the knowledge of the actor who engaged in the conduct at issue.

Usually, courts properly distinguish between the insured that is seeking contract recovery from the intent of the person whose conduct created the liability visited on the insured derivatively. This question gets played out in jurisdictions that do not afford indemnification for punitive damages, but allow insurance recovery where the punitive damages are imposed vicariously. Unigard Sec. Ins. Co. v. Murphy Oil USA, Inc., 962 S.W.2d 735 (Ark. 1998); US Concrete Pipe Co. v. Bould, 437 So. 2d 1061 (Fla. 1983); Glens Falls Indem. Co. v. Atlantic Building Corp., 199 F.2d 60 (4th Cir. 1952).

One also sees this in the first-party coverage context where the actions of an employee are not accidental – such as in committing arson – but which remain fortuitous from the standpoint of the insured (employer). In this context – or in any circumstance where corporate employees are involved and the corporation itself is seeking coverage – the landmark case is Northern Assur. Co. v. Rachlin Clothes Shop Inc., 125 A. 184, 188 (Del. 1924).

Recently, the West Virginia Supreme Court had occasion to address the unusual fact pattern of a sheriff and county commission seeking coverage for liability claims stemming from the suicides of two inmates in the country jail. Columbia Cas. Co. v. Westfield Ins. Co., No. 31941 (W. Va. June 10, 2005), available at http://www.state.wv.us/wvsca/docs/spring05/31941.pdf . The insurer denied coverage on the ground that the acts leading to the claim were not accidental – i.e., the inmates’ suicides themselves were not an accident or fortuitous event covered by the policy.

On certification from the US Court of Appeals for the Fourth Circuit, the West Virginia court ruled that coverage turned not on whether the acts leading to the liability claims were non-accidental but rather whether they were fortuitous or accidental from the standpoint of the insured seeking coverage. As the court stated: “[W]e hold that in determining whether under a liability insurance policy an occurrence was or was not an ‘accident’ – or was or was not deliberate, intentional, expected, desired or foreseen – primary consideration, relevance, and weight should ordinarily be given to the perspective or standpoint of the insured whose coverage under the policy is at issue.” (Slip op. at 9)

Where the entity – in Columbia Casualty, the county commission, or in corporate policyholder cases, the corporation itself – does not expect or intend the injury alleged (that is, where it did not expect or intend its agent to cause harm in completing his duties, compare Ashland Oil Inc. v. Miller Oil Purchasing Co., 678 F.2d 1293, 1317 (5th Cir. 1982); Travelers Indemnity Co. v. Bloomington Steel Supply Co., 695 N.W.2d 408 (Minn. App. 2005), ascribing the conduct of the harm-causing agent to the entity undermines its purpose in purchasing insurance in the first place: transferring to the insurer the risk of liability for harm or other loss caused by its employees. There is a difference between imposing liability vicariously as a matter of social policy, as in respondeat superior, and enforcing the terms of the insurance contract. Policyholders have the reasonable expectation that coverage will be afforded when loss occurs due to the acts of someone other than the insured seeking coverage.

This is what the Delaware Supreme Court correctly understood four score years ago in Rachlin and what the West Virginia Supreme Court correctly held in Columbia Casualty.

Posted by Marc Mayerson at 6:07 PM | Comments (2) | TrackBack

March 15, 2005

Contingent Business Interruption Coverage – Insuring Against Loss from One’s Dependence on Others

Business-interruption or business-income coverage protects against the risk that a casualty will affect the insured’s on-going ability to make a profit. When a fire damages a facility, the insured has a property loss for the costs of repair and a business-interruption loss from its inability to operate until the property is repaired. (An important related type of coverage is called “extra expense,” which indemnifies an insured for the additional expenses associated with, for example, maintaining temporary operations at an alternate location.)

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.

Posted by Marc Mayerson at 4:18 PM | Comments (1) | TrackBack

Contingent Business Interruption Coverage – Insuring Against Loss from One’s Dependence on Others

Business-interruption or business-income coverage protects against the risk that a casualty will affect the insured’s on-going ability to make a profit. When a fire damages a facility, the insured has a property loss for the costs of repair and a business-interruption loss from its inability to operate until the property is repaired. (An important related type of coverage is called “extra expense,” which indemnifies an insured for the additional expenses associated with, for example, maintaining temporary operations at an alternate location.)

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 (