Commercial property insurance claims frequently involve more than a mere loss of tangible business property. Economic damages in the form of loss of income from suspended operations, or from extra expenses suffered as a result of the loss are also typically sought by business owners. This article will examine the fundamental aspects of business interruption and extra-expense insurance coverages, and will provide an overview of several related cases.
Scope of Coverage
Business interruption insurance is designed to protect the prospective earnings of the insured business. It is also designed to do for the insured, in the event of a loss, what the business would have done for itself if an interruption in the operation of the business had not occurred.
Thus, business interruption insurance is designed to indemnify the insured-business against losses arising from its inability to continue the normal operations and functions of the business. Coverage is triggered by the total or partial suspension of business operations due to the loss, loss of use, or damage to all or part of the buildings, plant, machinery, equipment, or other personal property thereof, as the result of a covered cause of loss.
Coverage is generally provided for the "period of restoration", which is usually considered to be the period which would be required to rebuild, repair or replace the damaged property at the described premises with reasonable speed and similar quality. It usually commences with the date of such damage or destruction and it is not usually limited by the date of expiration of the policy.
Business interruption coverage is generally provided by a rider or endorsement to a commercial property insurance policy. The coverage typically provides that the insurer is not liable except for losses caused directly by a covered cause of loss, i.e., a hazard or peril insured against as a matter of contract. Moreover, actual profits and business expenses covered by the policy are usually determined in a manner which gives due consideration for the character of the business along with the manner in which it conducts its business activities.
Insured's Duties in the Event of Loss
Under the Insurance Services Office (ISO) Business Income Coverage Form, CP 0032 1091 (1990), a policy which is adopted by many insurers, the insured must see that the following are done in the event of a covered loss:
- Notify the police if a law may have been broken.
- Give prompt notice of the direct physical loss or damage. Include a description of the property involved.
- As soon as possible, give a description of how, when, and where the direct physical loss or damage occurred.
- Take all reasonable steps to protect the Covered Property from further damage by a Covered Cause of Loss. If feasible, set the damaged property aside and in the best possible order for examination. Also keep a record of expenses for emergency and temporary repairs for consideration in the settlement of the claim. This will not increase the Limit of Insurance.
- As often as may be reasonably required, permit inspection of the property proving the loss or damage and allow examination of books and records.
- Also permit to be taken samples of damaged and undamaged property for inspection, testing and analysis, and permit copies from books and records.
- Send a signed and sworn proof of loss containing the information requested to investigate the claim. You must do this within 60 days after request. We will supply you with the necessary forms.
- Cooperate with the investigation or settlement of the claim.
- If you intend to continue your business, you must resume all or part of your "operations" as quickly as possible.
Duties Imposed Under the Notice Provision
It is important to note at this point that the duties imposed under the notice provision (i.e., "[g]ive prompt notice of the direct physical loss or damage") are not to be considered as technical requirements merely for the convenience of the insurer, but rather are valid perquisites for coverage. Mitchell Buick & Oldsmobile Sales, Inc. v. National Dealer Services, Inc., 485 N.E.2d 1281 (Ill. App. Ct. 1985).
Many policy provisions which establish when an insured must notify its insurer concerning covered occurrences also require notification "within a reasonable time", considering all relevant facts and circumstances. When the material facts are undisputed, an insured's diligence in forwarding its notice to the insurer becomes solely a question of law. Grasso v. Mid-Century Ins. Co., 536 N.E.2d 977 (Ill. App. Ct. 1989).
Among the factors to be considered in determining if an insured has acted within a reasonable time in giving notice are:
- the presence or absence of the insured's sophistication in the world of commerce and insurance;
- awareness on the part of the insured that an occurrence as defined by the policy has taken place; and
- once aware of an occurrence, the diligence with which the insured ascertains whether policy coverage is available. American Family Mutual Insurance Company v. Blackburn, 566 N.E.2d 889 (Ill. App. Ct. 1991); appeal denied, 575 N.E.2d 911 (Ill. 1991).
It should be noted, however, that under Illinois law, if the insurer receives timely notice of the occurrence from a third party, this actual notice may satisfy the policy requirement for the insured to give notice to its insurer. Casualty Indem. Exchange v. Village of Crete, 731 F.2d 457 (7th Cir. 1984).
Necessity of Proof of Loss
As noted above, many current policies require that the insured submit a signed sworn proof of loss within 60 days of the insurer's request. Many other policies demand that the proof be submitted within 60 days of the date of loss, even if the insurer does not otherwise request the form. Needless to say, the period within which the proof can be filed can be waived or extended by the insurer.
It is interesting to note that in Gregory v. Continental Insurance Company, 575 So. 2d 534 (Miss. 1990), no proof of loss was submitted by the plaintiff prior to the filing of suit, and no written demand for payment was ever made on Continental. Subsequent to the filing of the suit, however, the plaintiff submitted the required documents and sought recovery under the terms of the policy.
The Court held that, although an insurer's duty to promptly pay a legitimate claim does not end because a lawsuit has been filed against it for nonpayment, Continental was not required under its contract to make any payment unless and until the proof of loss provisions of the policy were satisfied. Moreover, the Court concluded that the insured was not entitled to punitive damages where the terms of the policy obligated the insured to submit a proof of loss as a condition precedent to recovery, and where the insured had failed to do so.
It is important to note that the refusal of a corporation's officials to give information to their insurer in response to interrogatories, whether under advice of counsel or not, may be deemed to be a breach of the policy provision which requires an insured to submit to an examination under oath. Gipps Brewing Corp. v. Central Mfrs' Mut. Ins. Co., 147 F.2d 6 (7th Cir. 1945). Moreover, under Illinois law, fraud and false swearing is ordinarily a question of fact for the jury, but it becomes a question of law if the concealments or misrepresentations by an insured cannot in any way be seen as innocent. Lykos v. American Home Ins. Co., 609 F.2d 314 (7th Cir. 1979).
Upon close examination, it becomes evident that there are three separate components which must be connected in order to satisfy the requirements of the typical business interruption insuring agreement:
- A covered cause of loss must cause direct physical loss of or damage to the property at the described premises;
- The covered loss must cause a necessary suspension or interruption of operations; and
- The business income loss must be caused by the suspension or interruption.
For example, in Gregory v. Continental Insurance Company, 575 So. 2d 534 (Miss. 1990), the Court held that the business interruption loss coverage under a country club's multiperil policy did not cover the loss arising from the shutdown of the entire golf course after trees had been blown onto the course during a hurricane. Rather, the coverage was limited to the business income loss which resulted only from the damage to buildings specifically described in the policy.
Sitting en banc, the Mississippi Supreme Court in Gregory held that:
- The business interruption endorsement covered only the business loss resulting from damage to a building housing the pro shop and restaurant, not the loss from the shutdown of the entire golf course;
- The insurer was not liable for punitive damages on the basis of its pre-suit failure to pay anything under endorsement, since the requisite proof of loss was never filed; and
- Remand was warranted for the determination of the insurer's reasonableness in its postsuit conduct.
It is important to note that there is no prescribed or accepted formula for the determination of the actual loss of net profits and business expenses covered by business interruption insurance. The method employed, however, should test the past experience and the probabilities of the future, and the loss should be determined in a practical way, having regard for the nature of the business and the methods employed in its operation. Further, it should give practical effect to the intentions of the parties, and the purpose of the insurance, as evidenced by the terms, conditions, and provisions of the policy.
Thus, the insured's books and accounting system are not controlling in determining the recoverable loss under a business interruption policy of insurance. Nevertheless, they are not irrelevant and should be given such weight as practical judgment dictates.
The business interruption policy may be either "valued", in which case the value of the loss is agreed upon in advance and fixed by the policy, or "open", in which case the amount of any loss sustained is to be determined by competent proof. It is also possible for a policy to be partially valued and partially open.
Open policies have commonly provided for the recovery, during the time of the business suspension, of the insured's actual loss consisting of
- the net profits thereby prevented from being earned (or gross earnings, less the cost of production or less the cost of the merchandise sold);
- fixed charges and expenses necessarily continuing during the suspension period to the extent that they would have been earned, and;
- expenses incurred to reduce the loss.
Where the policy is open and the agreement of the insurer is to indemnify the insured, within the policy limits, for "actual loss", the burden is on the insured to prove the amount of loss, if any, that it has sustained. "Actual loss sustained" means lost net sales less the cost of goods sold, preparation costs, and selling and administrative expenses.
Accordingly, an insured may not usually recover the value of the remaining payments on leased equipment where the insured has already purchased new equipment with the insurance proceeds. Fireman's Fund Insurance Company v. Mitchell - Peterson, Inc., 578 N.E.2d 851 (Ohio Ct. App. 1991).
In Fireman's Fund, Mitchell-Peterson was the owner-operator of a Perkins Cake and Steak restaurant when a fire severely damaged the premises. The restaurant was insured under a fire policy issued by Fireman's Fund, and a claim was made for loss of income and additional expenses under the business interruption coverage. Fireman's denied several items claimed by the restaurant, and filed a declaratory judgment action.
The trial court held that the business interruption coverage included lost net sales less the costs of purchasing and processing the merchandise, plus continuing expenses. It awarded the restaurant approximately $83,000, but held that the period of restoration was fifty days shorter than the restaurant had claimed.
On appeal, the court noted that, in order to properly determine income loss as a result of a business interruption, there must be an allocation of direct labor and manufacturing overhead to calculate net income. It rejected the restaurant's argument that income should be defined as net sales of merchandise less the cost of merchandise as "far too simplistic". It affirmed the trial court's ruling that the "actual loss sustained" was lost net sales less the cost of goods sold, preparation costs, and selling and administrative expenses.
The restaurant contended that additional expenses in excess of the normal cost of operation should be awarded, including the cost of buying out the remaining payments on an equipment lease. The court, however, found that allowing such damages would operate as a windfall, since the restaurant was already paid for the value of the leased equipment under the property damages portion of the policy, and since it had subsequently purchased new equipment with those insurance proceeds, thereby, receiving new and undepreciated equipment as a result of the fire.
The appellate court ultimately concluded that the cost of the accelerated lease payment was not an actual expense made to return the business to normal operations. Judgment in favor of the insurer was affirmed.
Limitations on Recovery
Business interruption policies typically provide that the insurer will be liable, within policy limits, for the insured's fixed charges and expenses necessarily continuing during the period following a total or partial suspension of business. Generally, however, coverage is provided only to the extent that income would have been earned if the contingency causing the suspension had not occurred.
Thus, it should be noted that the ISO Business Income Coverage Form, CP 0032 (1091), states in pertinent part:
Resumption of Operations
We will reduce the amount of your Business Income loss to the extent you can resume your "operations," in whole or in part, by using damaged or undamaged property (including merchandise or stock) at the described premises or elsewhere.
If you do not resume "operations," or do not resume "operations" as quickly as possible, we will pay based on the length of time it would have taken to resume "operations" as quickly as possible.
* * *
a. Your business activities occurring at the described premises; and
b. The tenantability of the described premises, if coverage for Business Income including "Rental Value" or "Rental Value" applies.
Under a business interruption policy, issues frequently arise regarding whether the construction of the term, "expense", under the policy. In A. Miller & Company v. Cincinnati Insurance Company, 577 N.E.2d 885 (Ill. App. Ct. 1991), the plaintiff contended that the term "expense", as used in the policy, included the cost of the raw material used to replace the inventory which the company used to prevent a loss of income.
The Court held, however, that the term "expense" did not allow the insured to recover the costs of raw materials used to replenish his inventory since that would put the company in a better position than it would have been in if no breakdown had occurred.
Thus, the court concluded that allowing the raw material costs to be recovered under the policy would provide the insured with a double recovery. However, the court held that the term "expense" may include the costs for labor and utilities used in replacement of such inventory.
Also of interest is the case of Western America Inc. v. Aetna Casualty & Surety Company, 915 F.2d 1181 (8th Cir. 1990). In Western American, a fire destroyed most of Western America's adhesives manufacturing plant. Aetna insured Western and paid the losses for the plant and its contents. A dispute arose, however, over the interpretation of the policy's gross earnings and extra expenses clauses.
Aetna paid for the loss of gross earnings for 5 1/4 months of the suspension of business, but refused to pay for any extra expenses incurred to reduce losses during the rebuilding period. Western sued Aetna for lost rents, extra expenses and business interruption damages during the entire 10-month rebuilding period.
The jury awarded Western $759,616, the full extent of its coverage under the gross earnings clause, but denied recovery for lost rents and extra expenses. Aetna argued that Western failed to prove profit and expense figures which were necessary to calculate the business interruption damages under the gross earnings clause.
In its analysis, the court considered a dispute involving a similar Aetna policy in Associated Photographers, Inc. v. Aetna Cas. & Sur. Co., 677 F.2d 1251 (8th Cir. 1988), and approved essentially the same jury instruction. Aetna claimed the instruction was misleading because it did not specifically instruct the jury to consider the theoretical time period it would have taken Western to rebuild, and because it directed the jury to add time to the business interruption period for delays caused by Aetna.
Tracking the wording of Aetna's policy, the district court charged the jury as follows with regard to the issue of damages for business interruption:
- If your verdict is for Plaintiff Western Adhesives on its claim for loss of gross earnings due to business interruption, then, in determining Plaintiff Western Adhesive's damages under the Policy for Business Interruption (Gross Earnings) you should first determine from the evidence the length of the interruption period insured by the policy. If you determine from the evidence that there was a delay attributable to Defendant Aetna Casualty's failure to perform its duties under the policy, you may properly include that length of time in your calculation.
- If you find Western Adhesives suffered a loss of gross earnings due to business interruption as a direct result of the fire, you should award Western Adhesives for the actual loss of earnings you believe it sustained as a direct result of the fire (business interruption) plus any expenses Plaintiff incurred in reducing its loss of earnings.
- You are instructed that actual loss of earnings means the difference between the net profit you find Western Adhesives would have earned during the period of interruption and the net profit you find Western Adhesives did earn during the period of interruption.
- If you find in favor of Plaintiff Western Adhesives, then you must determine the date on which the proof of loss for loss of gross earnings (business interruption) coverage was filed and award plaintiff Western Adhesives interest from that date at the rate of 9% per annum.
The appellate court agreed with the district court that there was sufficient evidence for the jury to determine the extra expenses which served to reduce the loss to Western's business due to the fire, and concluded that Aetna established no error in the district court's denial of its motion for a new trial. Also, the appellate court held that the jury's verdict denying Western's extra expense claim was amply supported by the evidence. Thus, the judgment was affirmed.
Under a business interruption policy, issues frequently arise regarding whether an insured may include depreciation as an "expense" when the claimed business property has been totally destroyed.
The Court in Cohen Furniture Company v. St. Paul Insurance Company of Illinois, 573 N.E.2d 851, (Ill. App. Ct. 1991), held that an insured may not include depreciation as an "expense" under a business interruption policy where the business property has been totally destroyed, since depreciation only involves the useful life of an asset.
In Cohen, a dispute arose regarding the section of the business interruption policy which covered the "actual loss of earnings and extra expenses incurred because of necessary or potential interruption of business caused by covered direct damage to the building." An exclusion in the policy stated: "We won't include any charges and expenses which become unnecessary during the halt in your business."
The depreciation allowance represented the amount Cohen Furniture deducted on its income tax return for depreciation of the destroyed building and its improvements. In projecting loss of earnings under the business interruption policy, St. Paul subtracted from the earnings the "non-continuing expenses," i.e., expenses which were saved because the business was not in operation.
The appellate court held that St. Paul properly deducted the depreciation charge because an allowance for the depreciation can only be deducted during the useful life of an asset. Thus, a taxpayer cannot depreciate a non-existing asset. The court observed that once an asset has been destroyed, an insured cannot charge a depreciation expense.
It is important to note, however, that in Grevas v. United States Fidelity & Casualty Company, 604 N.E.2d 942 (Ill. 1992), the Illinois Supreme Court distinguished the appellate court's decision in Cohen.
In Grevas, the plaintiff owned an apartment building with coverage issued by USF&G. He suffered a loss by fire and applied to receive his net profits under the business interruption coverage. The amount was calculated by deducting the non-continuing expenses, such as utilities and lawn maintenance, from the building's gross income.
In addition, USF&G deducted an amount for depreciation of the premises, claiming that depreciation was an expense that was non-continuing. The trial court entered judgment for Grevas, finding that the policy was ambiguous as to whether depreciation was a non-continuing expense. The appellate court reversed and the plaintiff was granted leave to appeal.
The Supreme Court's distinction of Cohen and its reversal of the Appellate Court in the instant case was based upon a finding that, unlike the policy in Cohen, Grevas' policy contained coverage for both loss of gross earnings (a general clause), as well as, coverage for loss of rents (a specific clause). The Supreme Court further held that, in such cases, where both a general and a specific provision in a contract address the same subject, the more specific clause controls. Grevas at 944. Accordingly, the Supreme Court concluded that under the loss of rents provision, depreciation is solely a tax device and is not considered a noncontinuing charge or expense.
Policy Exclusions and Limitations
Most business interruption policies limit the insurer's liability to the extent that the business' charges and expenses would have been earned if the loss causing the interruption had not occurred. Partial business interruption limits the insurer's liability to a proportion of the liability that would have been incurred by a total suspension of business.
Further, the policy typically limits the period of recovery to the time required to repair, rebuild or replace the destroyed or damaged property with due diligence.
As noted previously, the insurer is generally liable for the "actual loss sustained" by the insured, resulting directly from necessary interruption of business, but not exceeding the reduction in gross earnings less charges and expenses which do not necessarily continue during the interruption of business.
For example, in Metalmasters of Minneapolis, Inc. v. Liberty Mutual Insurance Company, 461 N.W.2d 496 (Minn. Ct. App. 1990), the appellate court upheld the trial court's determination that Metalmasters incurred no "actual loss" in sales since Metalmasters presented no evidence of lost sales and proved no reduction in gross earnings.
The appellate court further agreed with the trial court that, without a proven actual loss, the business interruption coverage did not extend to the value of services provided by Metalmasters' president, in the amount of $60,000, which were used on cleanup during the interruption of business rather than to the advantage of the corporation.
Ambiguous Exclusion Language
An insurer may not usually rely on the definition section of a policy to define ambiguous terms which are used in the exclusion section of the policy to the extent that such an application of terms would preclude coverage in almost any situation.
For example, in Pressman v. Aetna Cas. & Sur. Co., 574 A.2d 757 (R.I. 1990), the plaintiff, a clinical psychologist, lost business because of a power failure when a tree adjacent to his property fell onto the power line that ran to his building. Because of the power outage, he was forced to cancel appointments with all of his scheduled patients, and he was unable to perform computerized diagnostic testing.
In addition, after the electrical power was restored, one of his two computers was not functioning. Pressman's business owner's insurer, Aetna Casualty, refused to reimburse him for his economic loss, claiming that coverage was excluded since the interruption of power took place away from the described premises. The trial court granted summary judgment in favor of Aetna.
On appeal, the appellate court determined that no issue of material fact existed, since no one contradicted the fact that the loss of power occurred when a tree collapsed on land adjacent to the property of the insured, severing the power line. It held that in construing the phase "away from the described premises", the trial judge had relied upon a definition of the term "premises" applicable to a different section in the policy.
To apply the special definition from another section to the exclusion section would preclude coverage in almost any circumstance, unless the insured had his own generator located inside the building, which, the court believed, would be unconscionable.
Thus, since it was not unreasonable for Pressman to have believed that his loss would be covered in these circumstances, the judgment was vacated, and the case remanded for trial on the merits.
Enforcement of Ordinance Exclusion
In Cohen Furniture Company v. St. Paul Ins. Co. of Illinois, 573 N.E.2d 851, (Ill. App. Ct. 1991), a fire destroyed the plaintiff's building, which had been built in 1971 and did not contain a fire suppression system. In 1978, the city's building code was amended to require the installation of fire suppression systems in the construction of all new buildings.
Following the loss, Cohen Furniture replaced the old store with a new building which included a $54,000 fire suppression system. However, the policy excluded losses caused directly or indirectly by the enforcement of any law governing the use, construction, repair or demolition of buildings.
The Illinois Appellate Court held that where an exclusion clause precludes coverage for losses directly or indirectly caused by the enforcement of an ordinance, the trial court should have granted summary judgement to the insurer where the insured rebuilt his building with a fire suppression system required by law, since the installation of such a system was a direct result of an ordinance and within the express terms of the exclusion.
Note: Other building loss exclusion cases cited by the court included Hertog v. Milwaukee Mutual Insurance Co. (1987) 415 N.W.2d 370; Stahlberg v. Travelers Indemnity Co. (1978) 568 S.W.2d 79; Unified School District No. 285 v. St. Paul Fire and Marine Insurance Co. (1981) 6 Kan.App.2d 244, 627 P.2d 1147; Hewins et al. v. London Assurance Corp. (1903) 184 Mass. 177, 68 NE 62. Hewins holds that the insurer is not liable for costs attributable to building law requirements, and is the most widely cited case upholding business laws exclusions.
It is interesting to note a contrary holding in the case of Linnton Plywood Assoc. v. Protection Mutual Ins. Co., 760 F.Supp. 170 (D. Or. 1991). In Linnton, the plaintiff prevailed in an action for business interruption by presenting evidence that its decision to suspend operations at the mill, in the absence of an adequate fire protection system, was consistent with its duty under the policy not to increase a hazard.
Confronted with an insured business interruption loss, risk managers should follow a nine-point plan.
- Notify the broker or agent and have them notify the insurer immediately;
- Continue to make decisions in the company's best interest, without regard for insurance coverage;
- Assign an account number and track all cost associated with the loss;
- Identify the people that know the impact of the loss and what needs to be done to restore operations;
- Determine the potential loss of sales;
- Identify the extra expenses that could minimize the loss of sales; such as the cost of continuing production at the current cite, moving to a new temporary cite, overtime pay, additional employees, or using replacement or rented equipment;
- Assess what must be done to get back into business, either at the current location or a temporary location.
- Gather all documents to submit the business interruption claim;
- Continue to cooperate with the insurer by providing requested documentation and access to company personnel.