Liability Insurance Coverage for Y2K Problems

Reprinted by permission of The American Bar Association and the Author

I. The Problem: Litigation Explosion?

Many computers programs use only the last two digits of the year in their date codes. Those programs face the possibility of the year "00" being read as 1900 instead of 2000. This so-called "Y2K" problem causes a failure in the programmed function as the computer erroneously interprets the "00" code for the year 2000 as occurring a hundred years earlier in 1900. The potential for damage seems limitless ranging from the failure of home computer checkbook programs to jet airliners falling out of the sky.

Prognosticators have predicted that compensatory and punitive damage awards arising from the Y2K problem could reach $1 trillion. They have predicted that hundreds of thousands of lawsuits will be filed relating to Y2K claims.

Large and small companies alike have begun efforts to remedy the problem. However, it seems unlikely that all companies will be fully compliant by 2000 or will be able to locate all problematic programming. Ultimately, lawsuits will be filed and a critical question for defendants facing Y2K claims will be whether their existing insurance will provide indemnity and/or defense for such claims. This article explores the potential for coverage for Y2K claims under the typical commercial general liability policy issued to businesses.

II. Typical Liability Coverages

The typical commercial general liability policy provides coverage in four areas: 1) bodily injury; 2) property damage; 3) personal injury; and 4) advertising injury. These terms are typically defined as follows:

7 "Bodily injury" means bodily injury, sickness or disease sustained by a person, including death resulting from any of these at any time.

7 "Property damage" means:

7 "Personal injury" means injury, other than "bodily injury," arising out of one or more of the following offenses:

7 "Advertising injury" means injury arising out of one or more of the following offenses:

Of these four covered categories, "bodily injury" and "property damage" present the most likely source of coverage for Y2K claims. A hypothetical Y2K fact pattern helps demonstrate the potential for coverage.

III. The Hypothetical

Railway Corp. operates a nationwide rail system. On January 1, 2000, at 5:00 a.m., a Railway Corp. train derails in Gary, Indiana. The cause of the accident is a malfunction in Railway Corp's computerized switching system. The system was unable to read the "00" date code and failed to switch the train onto the proper track in accordance with the schedule which had been programmed into the system.

After the Railway Corp. train derailed, the train struck Joe Driver's car causing substantial damage to the car and injuring Driver who was driving the car at the time.

The Railway Corp. train was transporting giant screen projection equipment to Theatre Co. in Detroit, Michigan. Theatre Corp. was opening a new giant screen theater and it had obtained the right to show the Super Bowl on January 14, 2000 at the grand opening of the theater. The 5,000 seat theater was sold out for the event. However, the projection equipment was destroyed when the train derailed, and Theatre Co. was forced to cancel the event and refund all ticket sales because it could not obtain replacement equipment before the Super Bowl.

Softco was the vendor who installed all the software and hardware for Railway Corp.'s computerized switching system. Softco installed the system in 1985.

Upon learning of the system failure in connection with the train wreck in Gary, Railway Corp. was forced to cease operations for two weeks while it repaired the problems. The shut down cost Railway Corp. millions of dollars of revenues.

All the parties had commercial general liability coverage from different insurers.

A. Driver v. Railway Corp.: Bodily Injury and Property Damage

Driver sues Railway Corp. for negligence for bodily injury suffered when his car was struck by the train. Driver also sues Railway Corp. for property damage to his automobile. This claim presents perhaps the clearest example of coverage. The Railway Corp. commercial general liability policy provides:

Driver's suit clearly seeks damages for bodily injury and property damage which was caused by the Y2K problem and the claims are within the coverage clause.

B. Theatre Co. v. Railway Corp.: Property Damage

Theatre Co. sues Railway Corp. for negligence. Among other things, Theatre Co. seeks damages for the loss of use of the projection equipment and loss of revenues from the canceled Super Bowl engagement. Railway Corp. tenders the lawsuit to its liability insurer. The claim for the destroyed projection equipment is clearly one for property damage within the coverage provisions of the commercial general liability policy. However, such policies typically include an exclusion for property which is damaged while in the custody, care or control of the insured. Here, the projection equipment was in Railway Corp.'s possession when damaged. Nonetheless, Theatre Co. is also claiming that it lost the use of its new theater by virtue of the loss of the projection equipment. The commercial general liability policy includes within the definition of property damage: "loss of use of tangible property that is not physically injured." Thus, if Theatre Co.'s claim is one for loss of use of the new theater, as opposed to a claim for pure economic losses, then it may trigger coverage under the commercial general liability policy.

C. Railway Corp. v. Softco: Property Damage

Railway Corp. sues Softco for breach of contract and negligence and seeks damages based upon the failure of the switching system. In all likelihood, the breach of contract claim will not be covered. The courts have generally held that liability policies cover only torts and not breach of contract. To the extent that Railway Corp. seeks lost profits or pure economic losses on a negligence theory, coverage will still likely be unavailable because pure economic losses are not covered under the property damage and bodily injury coverages. However, if Railway Corp. seeks damages against Softco for loss of use of its railway system, the potential for coverage may exist under the part of the property damage definition which includes "loss of use of tangible property that is not physically injured." Here, Softco would argue to its liability insurer that Railway Corp. is claiming damages for loss of use of tangible property which is not in Softco's possession or control (i.e., the railway system) as a result of Softco's negligence.

Even if Railway Corp.'s claim did not specifically allege loss of use of the railway system, but limited the allegations to failure of the computer system, coverage may still be available. Under this scenario, Railway Corp. is claiming that the Y2K problem has damaged its computer system or, alternatively, caused the loss of use of the system. The computer system is tangible property. Softco would argue that the alleged negligence falls within the definition of property damage and creates the potential for coverage. At least one case has held that an insurer has a duty to defend under a commercial general liability policy in similar circumstances. In Centennial Ins. Co. v. Applied Health Care Systems, Minicomputer Technology, Inc. (MTI) manufactured controllers used in Applied Health Systems, Inc.'s (Applied Health) data processing systems. Applied Health sued MTI alleging that the controllers had malfunctioned resulting in the random loss of customer billing and patient information. MTI tendered the lawsuit to its liability insurer, Centennial Insurance Company ("Centennial"), which denied coverage. The United States Court of Appeals for the Seventh Circuit, construing California law, held that Centennial was obligated to defend MTI because Applied Health's claims alleged potential "property damage" in the form of physical injury to Applied Health's computerized data processing system and/or loss of use of that system. Centennial is important because it creates the potential for coverage where the Y2K problem causes only economic harm and does not cause physical injury beyond the harm to the computer system.

IV. Exclusions and Other Coverage Defense Theories

A. Express Y2K Exclusions

Liability insurers have the ability to create and issue express exclusions which eliminate coverage for any claims arising from Y2K problems. In April 1998, the Insurance Services Offices, Inc. issued a series of proposed Y2K exclusions. However, there has been no consensus by liability insurers that such exclusions will be adopted. Two possible explanations exist. First, the soft market has caused some insurers concern that implementing the exclusion will cause them to lose business to other insurers who do not use the exclusion. Second, some insurers are concerned that the use of exclusion will create a negative implication that prior policies without the exclusion provided coverage for Y2K problems.

Even if insurers impose an express Y2K exclusion which is effective during the policy year including January 1, 2000, coverage for Y2K problems will not necessarily be eliminated. Policyholders may still be able to implicate earlier policies which do not include the exclusion. The issue of which policies are "triggered" has received substantial attention in connection toxic tort and progressive tort claims. A number of courts have adopted the so-called "incorporation" theory which provides that the policy on the risk at the time of the installation of a defective product is triggered. For example, in Eljer Mtg., Inc. v. Liberty Mut. Ins. Co., the United States Court of Appeals for the Seventh Circuit held that installation of defective pipe into a building constituted "property damage" under a liability policy. The Court further held that the policy on the risk at the time of installation (as opposed to the time when the leak occurred) was triggered.

The incorporation trigger theory could help avoid a Y2K exclusion. For example, in the hypothetical, Softco installed Railway Corp.'s software/hardware in 1985. If Softco's current policy (covering January 2000) contains an express Y2K exclusion, Softco, under the incorporation theory, can argue that the property damage occurred in 1985 and therefore the 1985 liability policy (which does not have a Y2K exclusion) is triggered.

B. Known Risk

Some liability insurers apparently assume that, even without a Y2K exclusion, no coverage will be available for Y2K claims in and after January 1, 2000 because the Y2K problem is a "known risk" and any resulting damage is not a fortuity. Under the "known risk" doctrine, insurance is only provided for a risk or loss where there is some contingency. If the loss has already occurred or is inevitable, it is uninsurable.

The Y2K problem has received enormous publicity and considerable regulatory attention. Thus, insurers may argue that the Y2K risk was known and not contingent. This argument seems unlikely to succeed. In the context of liability insurance coverage, the courts have held that liability in a third party lawsuit must be a "certainty" in order for the known risk rule to bar coverage. The "certainty" does not exist where there are disputed facts. Thus, for example, the Supreme Court of one state has held the known risk rule "will not defeat coverage for a claimed loss where it had yet to be established, at the time the insurer entered into the contract of insurance with the policyholder, that the insured had a legal obligation to pay damages to a third party in connection with a loss." Under this standard, even coverage issued during a pending Y2K lawsuit would not be barred by the known loss doctrine so long as liability had not yet been established in the lawsuit.

V. Y2K Insurance Policies

While coverage for Y2K problems may exist in certain circumstances under commercial general liability policies, these policies are not specifically tailored to cover Y2K issues. Currently, however, a few insurers are selling specialized Y2K coverage. For example, J&H/Marsh McLennan is offering Y2K coverage through the Lloyds market. American International Group and Aon are also offering Y2K coverage. The coverages typically are quite expensive, have large deductibles and may require a professional pre-coverage audit, at the insured's expense, to determine whether any Y2K problems exist. In light of these drawbacks, the coverage is not a universal solution to Y2K exposure.

CONCLUSION

Y2K claims and litigation have started and will only increase in the coming months and years. Commercial general liability policies offer some protection -- albeit not complete -- from such claims. Careful analysis of Y2K claims and the liability coverage provisions will be necessary to maximize the protection.