Y2K Coverage: Is Your Insurance Business Covered?

The "Y2K" problem has received substantial attention in recent months. The problem arises from the programming used in many computers and microchips, which designates only the last two digits of the year in the date codes. The programs read the year "00" as 1900 instead of 2000. This flaw may cause the program to malfunction.

The Y2K problem exists in a staggering array of products and industries, ranging from electric power grids and nuclear missiles to bank cash machines and home computer software. Some pundits have predicted that January 1, 2000, will bring massive power failures, the loss of banking records, the inability to withdraw money from bank accounts, and widespread failures in the transportation and manufacturing sectors. There have been predictions of hundreds of thousands of lawsuits being filed relating to Y2K claims and compensatory and punitive damage awards arising from those suits in an amount as high as $1 trillion. These dire predictions may well be overblown. However, there is no question that the Y2K problem will cause some failures and dislocation and will result in litigation by those who are affected by the problem.

Indeed, by late 1998, over a year before the ominous January 1, 2000, date, at least 25 lawsuits had already been filed seeking damages based upon Y2K problems. The suits include claims by hospitals, medical offices and consumers alleging damages based on the failure of software to be able to process dates after January 1, 2000.

With the looming inevitability of Y2K lawsuits, the question thus becomes for many small business owners what type of coverage is available for protection against such claims. Currently, a few insurers are selling specialized Y2K coverage. J&H/Marsh McLennan is offering Y2K coverage through the Lloyds market. American International Group and Aon are also selling specialized Y2K coverages. However, these coverages are quite expensive, have large deductibles and may require extensive pre-coverage audits, at the policyholder's expense, to analyze the policyholder's vulnerability to Y2K problems. Thus, as a practical matter, specialized Y2K coverage may not be available or may be uneconomical for many policyholders.

Without specialized Y2K cover, you'll need to look to other existing coverages for protection. Most businesses maintain commercial general liability (CGL) insurance to cover liability exposures. Will commercial general liability insurance provide coverage for Y2K claims? The answer may be "yes" in a number of situations, although a careful analysis of the alleged damages in the Y2K claim and the policy provisions will be necessary.

CGL policies typically provide coverage in four areas: (1) bodily injury; (2) property damage; (3) personal injury and (4) advertising injury. Most likely, coverage for Y2K claims will be available, if at all, under the bodily injury and property damage coverages.

A few examples help illustrate the existence and absence of coverage for Y2K claims under a CGL policy. An easy case is one where a person is injured as a result of a Y2K problem. For example, if a train derails as a result of a Y2K failure in a switching mechanism and the train collides with an automobile injuring the automobile's passengers, the claims by the passengers against the railroad company for personal injury should be covered under the bodily injury coverage in the CGL policy. Likewise, claims for property damage by the automobile's owner should also be covered under the railroad's CGL policy.

Unlike bodily injury and property damage, pure economic loss is generally not covered under a CGL policy. Therefore, for example, if a Y2K problem causes a supplier to fail to ship materials to a manufacturer, and the manufacturer thereafter files a lawsuit against the supplier for lost profits due to a shutdown of the manufacturing process, the claim, in all likelihood, will not be covered. Pure lost profits do not constitute property damage, which is normally defined to mean physical injury to tangible property. Nonetheless, CGL policies usually include an alternate definition for "property damage," which includes loss of use of tangible property that is not physically injured. This alternate definition may provide a basis for the coverage in a variety of situations. Whenever the policyholder's Y2K problem has caused a third party to suffer a loss of use of its property, coverage may be triggered. The following are a few possible examples:

In each of these instances, the plaintiff making the claim against the policyholder has lost the use of its property as a result of the policyholder's Y2K problem, even though there has been no physical damage to the property. Each of these circumstances presents at least the possibility for coverage under the property damage coverage of a CGL policy.

A difficult issue arises when the Y2K problem causes only the computer system in question to fail and does not cause the loss of use of any other property. Does the existence of the defective programming or software, which causes the Y2K problem, cause "property damage" to the computer system itself? Will any such "property damage" be sufficient to trigger any duties of an insurer under a CGL policy?

At least one court construing California law has held that a failed component of a computer system does cause "property damage" to the computer system within the meaning used in the CGL policy. In this case, a medical company sued a computer company that had supplied components used in the medical company's data processing systems. The component failed causing random loss of customer billing and patient information. The computer company tendered its claim to its insurer under a CGL policy. The court ruled that the claims alleged "property damage" in the form of physical injury to the medical company's computer system and/or loss of use of the system. Thus, the court held that the insurer had a duty to defend the medical company under the CGL policy. The same reasoning seems applicable to Y2K claims. The existence of the Y2K problem causes physical injury to the computer system in question and/or loss of use of that computer.

Even if potential coverage exists for a Y2K claim under a CGL policy, the insurer may try to avoid coverage through the use of various exclusions. The most direct exclusion would be one restricting coverage for Y2K claims. However, to date, there has not been a widespread use of Y2K exclusions by liability insurers. A couple of reasons may exist. First, the market has been soft and at least some insurers may fear a loss of customers if the Y2K exclusion is implemented. Second, some insurers may feel that the use of a Y2K exclusion for the first time in a policy covering January 1, 2000, may be interpreted as an admission that policies without such an exclusion would provide a coverage for Y2K claims.

Even if an insurer includes a Y2K exclusion in the policy covering January 1, 2000, the exclusion may not eliminate all coverage for Y2K claims. Under California law, the policy on the risk at the time the damage occurred is triggered. At least some courts have ruled that "property damage" occurs upon installation of a defective component into the property in question. Thus, for example, property damage under a CGL policy occurs at the time asbestos is installed into a building. Under this reasoning, the property damage to a particular computer system where software or programming is unable to read a two digit "00" date code occurs at the time of the installation of the faulty programming or software. Likewise, the policy on the risk at the time of the installation of the faulty programming or software will be triggered. In almost every case, the programming or software will be installed years before the Y2K problem arises on or after January 1, 2000. Accordingly, the policyholder will be able to implicate the earlier policy without running into the bar of an explicit Y2K exclusion on a current policy.

Insurers faced with Y2K claims may also argue that coverage is not available for Y2K claims because the Y2K problem is a "known risk" and any resulting damages are not a fortuity. Under the "known risk" doctrine, insurance is only provided where there is some contingency. Here, the insurers will argue that the Y2K failure was inevitable and that policyholders knew of the problem well in advance of any failure given the extraordinary publicity that has occurred before January 1, 2000.

In all likelihood, the "known loss" doctrine will not protect insurers in connection with Y2K claims. The California courts have ruled that liability in a third party lawsuit must be a "certainty" in order for the known risk rule to bar coverage. Thus, so long as the CGL coverage incepted prior to any judgment finding liability on a Y2K problem, the Y2K claim will not be barred by the known risk doctrine.

Policyholders may face a related issue. If the policyholder renews, or seeks to purchase new, CGL insurance during 1999, the insurer may require the policyholder to complete an application. The application may seek information concerning existing or potential Y2K claims. Disclosure of existing or potential claims by the policyholder will likely result in a specific exclusion for such claims. However, the failure to disclose such claims could result later in an attempt to rescind the policy by the insurer.

In sum, it is inevitable that the Y2K problem will result in litigation. While the typical CGL policy will not cover all Y2K claims, such policies will afford the opportunity for defense and indemnity as to some claims.