Previously published in New York Law Journal
Business interruption losses caused by supply chain disruptions are rising as manufacturers increasingly rely on factories around the globe to supply necessary components for their products. Two significant examples of supply chain disruptions in 2011 that caused widespread losses for manufacturers were the earthquake/tsunami in Japan and the massive flooding in Thailand. Factories that manufacture critical components for the automobile and technology industries were unable to provide their customers with necessary components. With supply disrupted, manufacturers were forced to stop or limit their operations.
Contingent Business Interruption (CBI) insurance coverage may be available to pay for a company's losses due to such supply chain disruptions. However, CBI coverage is complicated and requires a thorough understanding of the policy and related issues, such as applicable deductibles, the scope of the business interruption, the calculation of loss, and potential applicability of exclusions. This article provides an overview of what you need to know in order to maximize recovery from a property insurance program after business is interrupted due to a supply chain disruption.
Many companies use just-in-time supply systems, significantly increasing the importance of CBI coverage when supply chains are disrupted. While such systems benefit the company when operating at full capacity, any disruption may result in an enormous loss when a company cannot acquire materials it needs to meet its production capacity. A significant downturn in supply almost always results in increased costs to acquire the materials needed to continue operating and can even result in partial or complete shutdown of facilities lacking the resources to operate.
Companies suffering supply chain losses often do not realize that they may be protected by their insurance program, even if the company itself has not suffered any damage to its own property. Counsel familiar with the nuances of this insurance coverage can provide valuable advice to a company seeking to maximize its recovery for loss from a disruption in its supply or distribution chain. Experienced counsel can give the company the best chance to prove its loss during the claim adjustment process, or, potentially, during litigation if the company's claim is rejected by its insurance company.
Types of Coverage
Most companies purchase first-party property insurance policies that protect against loss from fire or other destruction of their own property. These policies often include business interruption coverage, which insures against loss when the insured's "business is partially or totally interrupted as a result of a covered property damage."1 Such coverage generally requires that the loss caused by the interruption be the result of damage to the policyholder's own property that is covered under the policy. Therefore, "regular" business interruption coverage likely will not provide protection for losses to companies located in New York arising out of events in other countries or other parts of this country.
CBI insurance clauses extend business interruption coverage under certain circumstances. One such circumstance is when a peril of the type covered by a policy causes damage to a supplier of the policyholder. CBI insurance also often provides coverage when a covered peril damages a receiver or distributor of a policyholder's goods. In addition to CBI coverage, many property insurance policies also contain coverage for extra expenses that a policyholder incurs as the result of a covered event. Policies often extend extra expense coverage to include situations where extra expense is incurred because of damage to the property of a policyholder's suppliers, receivers, and distributors. Together, these coverages can provide a policyholder with broad protection against unforeseen disruptions to its supply or distribution chain.
CBI insurance protects against losses resulting from damage to the policyholder's suppliers, distributors or receivers. Nevertheless, some important limitations exist that a policyholder must consider.
For instance, many CBI provisions require that the damage be suffered by a "direct supplier of goods." A policyholder, therefore, should be careful in describing its supply chain to avoid later disputes regarding whether a supplier is a "direct supplier" to the policyholder. Further, the question of what constitutes a supplier within CBI coverage is not always clear. Recently, in Park Electrochemical v. Continental Casualty,2 Judge Eric Vitaliano, of the U.S. District Court for the Eastern District of New York, found that the term "direct suppliers" was ambiguous and ordered trial on the issue of whether a foreign facility owned by the insured could be considered a "direct supplier" of goods to the insured for purposes of CBI coverage.
CBI insurance also typically only applies if the third party suffers loss caused by a peril for which the policyholder itself is covered. Any limitation on a policyholder's coverage for loss because of earthquake, windstorm, or flooding may impact the policyholder's ability to recover for an interruption to business caused by that type of loss to a supplier. For example, in the aftermath of a hurricane, insurers and policyholders often dispute whether losses were caused by windstorm, storm surge, or flooding. Policyholders should retain attorneys and consultants early to examine the issue of causation, particularly where the facts regarding that loss are in the hands of third parties.
Consider a policyholder that has property insurance that includes earthquake damage, but excludes damage from flooding. If a supplier of that policyholder suffered damage in the aftermath of the Tohoku earthquake and tsunami, that policyholder must recognize that its insurer may contend that the damage was caused by flooding and not by earthquake. It is therefore critical for the policyholder to gather important information regarding the damage to the Japanese company in a contemporaneous and timely manner. It is often difficult to re-create this proof later during the claim adjustment process when the evidence needed is in the possession of a supplier located on the other side of the world.
Other limitations in the policy may not restrict the CBI coverage. For instance, typically first-party property policies contain a geographic limitation in terms of the territory within which the policy provides coverage. In Park Electrochemical, the insurer sought summary judgment contending that because the damage causing the loss was suffered by a facility located outside of the "Territorial Limits" of the policy, the CBI provisions of the policy did not provide coverage. Judge Vitaliano disagreed, ruling that the loss was the "financial shortfall" that was suffered at the policyholder's headquarters, not the physical damage to the foreign facility.3
Insurance companies also may defend against CBI claims by arguing that the policyholder must suffer a total and complete cessation of operations before its business is interrupted. Many courts reject this overly strict interpretation of policy provisions covering a "necessary interruption" or "suspension" of business. The rejection of this insurer argument is particularly important for a CBI claim, as a disruption in supply or distribution may only impact one aspect of a policyholder's business.
One federal court noted that use of the term "necessary interruption" in a CBI provision did not require a complete shutdown of the policyholder's entire business.4 However, some New York courts have found that a complete shutdown of business operations is necessary under conventional business interruption coverage.5 Policyholders should consult with counsel soon after a loss to carefully determine the impact of an interruption on the policyholder's business and the requirements for coverage under the policy.
Extra Expense Insurance
"Extra expense" insurance, contained in many policies, covers "reasonable and necessary extra costs" a company incurs in excess of the normal operating costs in order to keep its business operating after damage to the company's property. Often, policies with CBI provisions also provide for extra expense insurance covering extra costs incurred because of damage to the facilities of a supplier, receiver, and/or distributor, such as increased costs to the policyholder caused by an inability to receive a supplier's goods. Expenses incurred to reorganize shipping and supply systems may also fall into this category of covered losses.
It is critical that a company keep detailed records regarding all efforts at reorganization and the expenses incurred resulting from the efforts of its employees to identify alternatives to the disrupted supply or distribution system.
When Making a Claim
A policyholder must act in a timely fashion when seeking coverage under any insurance policy, including a policy containing CBI provisions. Notice should be given promptly if the company suspects that it might suffer an interruption-related loss in order to avoid its insurer rejecting the claim on the grounds that notice was not timely. Property insurance policies also often require the policyholder to submit a proof of loss within a specific and relatively short period of time after a loss. This requirement often proves quite difficult if not impossible for a complicated and potentially ongoing interruption caused by damage to a third-party supplier, receiver, or distributor. Accordingly, a company should keep its insurer fully informed of the status of its claim and should request extensions of time in which to submit a proof of loss as needed.
Interruption losses also are often difficult to quantify. Property insurance policies typically provide for one of two alternative methods for calculating business interruption and CBI loss: (1) gross earnings—the net reduction in earnings less the expenses that do not necessarily continue during the interruption; or (2) business income—the profit that would have been earned plus continuing normal operations expenses during the period of interruption.
Proving an interruption-related loss in either case involves a complicated process of demonstrating how the policyholder would have performed had the event not occurred, the nature of the market in general, and even the impact of the catastrophic event on that market. This difficulty of proof underscores the need for thorough documentation of losses and expenses during the interruption so that claims can be properly supported.
Any policyholder should be wary that its own analytical material may become a hurdle to its recovery. Insurance companies and the adjustors they retain have an incentive to reduce the amount of a claim, and will use the policyholder's own analytics against it, if possible. A policyholder can effectively and thoroughly track the extent of its loss by immediately hiring experts to assist in adjusting the claim. A policyholder should also retain coverage counsel early to place its own analytics in perspective and provide advice on the scope of the losses covered by the policy. Proper calculation of a CBI or extra expense claim takes time and involves many participants. Coordination with the adjustment team and counsel often is one of the most important steps and should be implemented at the beginning of the process to maximize potential recovery.
Companies that have suffered an interruption in their business due to supply chain disruptions often overlook potential CBI and extra expense coverage. Any company that has suffered an interruption-related loss should give notice to its insurer and implement good record-keeping, careful tracking of expenses, and control over its internal communications.
The company should also maintain open communication with the third party that suffered damage because proving damage to that third party is vital to the company's insurance recovery efforts. Lastly, a company's early retention of experts and experienced counsel is integral to minimizing the impact to its bottom line caused by a disruption to supply or distribution systems resulting from a catastrophic event.
1. Duane Reade v. St. Paul Fire and Marine Ins., 600 F.3d 190, 192 n.2 (2d Cir. 2010) (citation omitted).
2. Park Electrochemical v. Continental Casualty, No. 04-cv-4916, 2011 WL 703945 (E.D.N.Y. Feb. 18, 2011).
3. Park Electrochemical, No. 04-cv-4916, 2011 WL 703945, at *4.
4. Archer Daniels Midland v. Aon Risk Services of Minnesota, 356 F.3d 850 (8th Cir. 2004).
5. See, e.g., 54th Street Ltd. Partners v. Fidelity and Guaranty Insurance, 306 A.D.2d 67, 763 N.Y.S.2d 243 (1st Dept. 2003).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.