Contingent Business Interruption Coverage

Given the growing interdependence between companies, both domestic and foreign, insureds and risk managers alike are increasingly aware of the need to guard against world events that may have a lasting impact on the insured's business. Despite its limitations, contingent business interruption coverage can provide that much needed protection.

William P. Shelley, a member of this newsletter's Board of Editors, is chairman of the Global Insurance Group of Cozen O'Connor and currently serves on the firm's Board of Directors and Management Committee. Lawrence Bowman is a member of the firm in Dallas, concentrating his practice in the areas of complex commercial litigation. Kendall Hayden and Samantha Evans are associates in the firm's Global Insurance Group.

Contingent business interruption (“CBI”) insurance provides coverage to an insured when a supplier or a key customer suffers a direct physical loss that interrupts the insured's own business (e.g., revenue stream). Bruce R. Kaliner, The Expanding Role of Contingent Business Interruption Insurance, ' 17 MEALEY'S BUSINESS INTERRUPTION INS. (Volume 3, 1st Ed. 2003). Just as property insurance generally restores damaged real or personal property, business interruption (“BI”) insurance is intended to restore profits lost as a result of an insured casualty event, placing the insured in the same financial situation as if the loss had not happened. BI insurance protects against the loss of prospective earnings because of the interruption of the insured's business caused by an insured peril to the insured's own property. Jess B. Millikan, Practice Tips: Time Element Losses During Catastrophes, 31 The Brief 52 (ABA Spring 2002). In contrast, CBI insurance protects against the loss of prospective earnings because of the interruption of the insured's business caused by an insured peril to property that the insured does not own, operate, or control. CII Carbon, L.L.C. v. National Union Fire Insurance Company of Louisiana, Inc., 918 So.2d 1060, 1061 n.1 (La. Ct. App. 2005).

CBI insurance is becoming a more prevalent component of property coverage as a result of converging economic and world events. Risk managers are increasingly becoming sensitive to the fact that world events such as terrorism or riots, regional incidents such as power blackouts or hurricanes, or local occurrences such as strikes, fires, floods, or explosions can have far-reaching effects on their company even if supply chain risk solutions, crisis management, or business contingency plans are in place.

Purpose of CBI

Some businesses lose income due to loss or damage to property at the insured's premises, while many businesses suffer losses from damage to property of others on whom the businesses are dependent. Paula B. Tarr, Where have all the customers gone? Business interruption for Off Premises Events, 30 The Brief 20 (ABA Winter 2001). CBI coverage is designed to insure the individual business or the individual whose income is largely contingent or dependent on the property of some other business entity; in other words, CBI protects insureds who sustain an interruption of their own business caused by an interruption in the flow of goods or services provided by other businesses. Id.

Practical Applications of CBI Concepts

Contingent business interruption losses may occur at a variety of locations: 1) physical damage or destruction may occur to an insured's supplier's real or personal property, which makes the supplier unable to provide the needed goods or services to the insured (a “Contributing Location”); 2) the insured's customers cannot receive or use the insured's goods or services because of physical destruction or damage to the customers' real or personal property (the “Recipient Location”); 3) physical damage or destruction occurs to the property where products are manufactured for delivery to the insured's customers under a contract of sale (the “Manufacturing Location”); or 4) physical damage or destruction occurs to the property of the nearby business that attracts customers to the insured business (the “Magnet Location”). Id. While a discussion of each of these types of premises is beyond the scope of this article, the following is an example of damage at a Contributing Location.

CII Carbon, L.L.C. v. National Union Fire Insurance Company of Louisiana, Inc. , 918 So. 2d 1060, 1061 at n.1 (La. Ct. App. 2005), provides a good illustration of the distinction between BI coverage and CBI coverage and demonstrates damage to a Contributing Location. The insured, CII Carbon, owned a coke plant that processed coke by heating petroleum coke in kilns to make it suitable for use in the aluminum smelting industry. While the heat-treated coke was sold to CII Carbon's customers, it captured the heat that escaped from the coke kilns during the heating process and used it to operate a boiler that generated steam. CII Carbon either sold the steam to neighboring plant owners or used the steam to generate electricity that it also sold.

Kaiser Aluminum and Chemical Corporation (“Kaiser”) owned and operated a Bayer plant and a powerhouse, both of which were in the same location as the CII Carbon Coke plant. The steam produced by CII was sold to Kaiser for use in the Bayer plant. CII Carbon subleased equipment located in the Kaiser powerhouse that was necessary for CII Carbon to operate the boiler that produced the steam that CII Carbon sold. The boiler could not operate unless the subleased equipment at the powerhouse supplied water to the boiler and accepted the generated steam.

On July 5, 1999, a massive explosion at the Kaiser Bayer plant caused extensive damage to the powerhouse equipment that was subleased to CII Carbon. Although the powerhouse equipment that CII Carbon subleased was repaired by Nov. 15, 1999, the Bayer plant did not resume operations until Dec. 31, 2000, and CII Carbon was unable to sell steam to Kaiser between July 5, 1999 and Dec. 31, 2000.

The CBI provision in the policy had a limit of $500,000, while the BI provision offered a higher limit. The insured contended CII Carbon was entitled to coverage for its loss of steam sales from July 5, 1999 through Nov. 15, 1999 under the BI clause of the policy. The insurer took the position that CII Carbon's loss of steam sales for the period of Nov. 16, 1999 through Dec. 31, 2000 was covered solely by the CBI clause of the policy. By contrast, the insured contended that the loss of steam sales for the period of Nov. 16, 1999 through Dec. 31, 2000 should have been covered under both the BI and CBI clauses of the policy.

The trial court held: 1) CII Carbon sustained a BI loss from July 5, 1999 through Nov. 15, 1999, when the repairs to the subleased equipment were completed and the equipment could have been, operational; and 2) CII Carbon sustained a CBI loss between Nov. 15, 1999 and Dec. 31, 2000, when the Kaiser Bayer plant resumed its normal operations.

On appeal, the Louisiana Court of Appeals affirmed, ruling that coverage under the BI clause terminated at the time repairs to the subleased powerhouse equipment were completed and that coverage after that time for loss of steam sales was governed by the CBI provision.

CII Carbon demonstrates how CBI coverage operates to insure damage or destruction to a supplier's real or personal property, which makes the supplier unable to provide the needed goods or services to the insured.

Limitations on CBI

Although case law on CBI losses is limited, jurisdictions have addressed the scope of this coverage. For instance, while the direct physical loss or damage need not shut down the dependent property for a CBI loss to be covered, if the damaged dependent property is at a premise other than a scheduled location, the coverage is generally very limited. Paula B. Tarr, Where have all the customers gone? Business interruption for Off Premises Events, 30 The Brief 20 (ABA Winter 2001); Pentair, Inc. v. American Guar. & Liab. Ins. Co., 400 F.3d 613 (8th Cir. 2005). Further, a business interruption loss to the insured does not afford contingent business interruption coverage if the business interruption loss is to a subsidiary of the insured rather than the insured. Finally, CBI coverage is also limited or otherwise unavailable when the property damaged is not the property of one who supplied or received merchandise from the insured. Pentair, 400 F.3d at 613.

The Direct Physical Loss or Damage to Dependent Property Must Result from a Covered Peril at the Requisite Location

CBI coverage requires that the direct physical loss must be to the supplier's or customer's property. Although the insured will have its own physical damage or pecuniary loss, the actual direct physical loss or damage must be sustained by the supplier or customer ' which distinguishes BI coverage from CBI coverage. Bruce R. Kaliner, The Expanding Role of Contingent Business Interruption Insurance, ' 17 MEALEY's BUSINESS INTERRUPTION INS. (Volume 3, 1st ed. 2003). Some courts extend the direct physical loss requirement to situations where products, premises, or locations become unsafe or unsuitable, while other courts require structural damage to the property.

Further, there must be a suspension of the insured's operations. Coverage does not apply if the insured's operations were unaffected by the physical loss or damage to dependent property. Paula B. Tarr, Where have all the customers gone? Business interruption for Off Premises Events, 30 The Brief 20 (ABA Winter 2001).

Third, the suspension of the insured's operation must be caused by the physical loss or damage to dependent property. Id. Coverage does not apply if the insured's business would have been inoperable anyway; for example, if the same storm caused suspension of the insured's operations and damaged a dependent property as well, damage to the dependent property would not be covered. Id.

Finally, an insured must sustain an actual loss of business income during the period of restoration. Id. If the insured's cash-flow is not affected by the physical loss or damage to the dependent property because the insured has sufficient inventory to meet orders during the period of restoration, there is no recovery.

Loss of sales after the period of restoration is not recoverable. Id.

Moreover, actual loss of business income must be caused by the suspension that resulted from the physical loss or damage to dependent property. Id. There can be a reduction in business income caused by the peril that is not caused by a suspension of the insured's operations that resulted from physical loss or damage to dependent properties. Id. For example, if the peril is storm damage and bad weather simply influences people to stay home, or people are too occupied with their own storm-related problems, potential customers may choose not to patronize the insured business. Id. Falloff in business income resulting from such factors is not the consequence of suspension of the insured's operations and would not be indemnified under contingent business interruption coverage. Id.

No CBI Coverage If the BI Loss Is To a Subsidiary of the Insured

Pentair, Inc. v American Guar. & Liab. Ins. Co., supra, addressed contingent business interruption coverage and the limitations that arise when the loss occurs to an entity that is not the entity named or otherwise insured under the policy but is in some way affiliated with the insured. In Pentair, an earthquake struck Taiwan, disabling a substation that provided power to two Taiwanese factories. The two factories, without power, could not manufacture products that they supplied to a subsidiary of Pentair, the insured. Pentair sought to recover under the contingent business interruption clause of its policy. The trial court held there was no coverage, and the Eighth Circuit Court of Appeals affirmed.

First, although the two factories were suppliers of Pentair, the substation that was physically damaged was not a supplier of Pentair. The court of appeals explained that although the substation provided power to the two factories, it did not provide a product or service ultimately used by Pentair. Second, the court rejected Pentair's argument that the power outage caused direct physical loss or damage to the two factories because the factories were unable to perform or produce products. The court held that mere loss of function does not constitute direct physical loss or damage. As the court explained, if Pentair's argument were adopted it “would mean that direct physical loss or damage is established whenever property cannot be used for its intended purpose.”

Contingent Property Does Not Supply or Receive Merchandise From the Insured

In Royal Indemnity Company v. Retail Brand Alliance, Inc. , 33 A.D.3d 392, 822 N.Y.S.2d 268 (2006), the court ruled that the insured, which owned a Brooks Brothers store near the World Trade Center, could not recover contingent business interruption coverage. The court held that although Brooks Brothers contended it depended on the World Trade Center for its income stream, it was not a “dependent” property because the businesses in the World Trade Center (i.e., the properties that suffered the direct physical loss or damage) did not supply or receive merchandise from Brooks Brothers. As the court summarized,
“[t]he fact that individuals that worked in the WTC also purchased clothing at Brooks Brothers does not render the WTC a dependent property.”

Conclusion

Contingent business interruption insurance, unlike traditional property or business interruption coverage, insures against losses caused by damage to property the insured does not own and cannot otherwise control. This type of insurance protects a particular type of insured ' insureds with businesses that depend on other businesses for sustainability or survival.

While CBI insurance provides many benefits to a dependent insured, it is not without its limitations. Courts have limited the scope of its coverage to dependent property damaged by a covered peril at a designated location. Other courts have limited its reach when the insured's subsidiary suffers a loss and when the contingent property did not supply or receive merchandise from the insured.

Given the growing interdependence between companies, both domestic and foreign, insureds and risk managers alike are increasingly aware of the need to guard against world events that may have a lasting impact on the insured's business. Despite its limitations, contingent business interruption coverage can provide that much needed protection.

William P. Shelley, a member of this newsletter's Board of Editors, is chairman of the Global Insurance Group of Cozen O'Connor and currently serves on the firm's Board of Directors and Management Committee. Lawrence Bowman is a member of the firm in Dallas, concentrating his practice in the areas of complex commercial litigation. Kendall Hayden and Samantha Evans are associates in the firm's Global Insurance Group.