Business Interruption Insurance - What you need to tell your clients

by David Goodwin and Greg Rubio, Covington & Burling LLP

This practice note discusses insurance coverage for times when business is interrupted because of property damage or loss.

Scope of Coverage

Because property insurance policies typically cover only the cost of repairing and replacing damaged property, and not consequential economic losses, many purchasers of commercial property insurance purchasers add business interruption and other forms of “time element” insurance. This is done to provide coverage for the various types of economic losses that may result when a business is unable to put its property to its normal commercial use for some period of time.

This coverage generally protects against the risk of loss of earnings that the insured would have enjoyed from its operations but for the suspension or slowdown of operations resulting from the property damage.

The fundamental purpose of business interruption or time element insurance, as stated by one state’s high court, is to “do for the business what the business would have done for itself had no loss occurred . . . [t]ypically [by] computing the earnings lost during the period necessary to restore the business to its pre-accident condition.” Thus, business interruption insurance provides coverage for the loss sustained when a risk or peril covered under the commercial property insurance contract causes property damage that, in turn, leads to economic losses, subject to the limitations and exclusions stated in the policy.

Insurers frequently offer commercial time element insurance that includes a variety of “extensions” of coverage beyond basic business interruption coverage. These extensions protect against economic losses resulting from a wide variety of circumstances, including:

• Losses in business income resulting from government actions that prohibit or prevent access to the insured’s premises, covered under “civil authority provisions” in some property insurance contracts
• Losses resulting from the disruption of a business-critical utility service by a covered peril, known as “service interruption” coverage
• Losses of revenue from damage or destruction to the insured’s inventory, known as “profit and commission” coverage.

Insurers provide these and other forms of business interruption coverage through many types of coverage forms. These include for smaller businesses, certain standard ISO forms, such as the ISO “Business Income (and Extra Expense) Coverage Form,” as well as the ISO “Building and Personal Property Coverage Form” (“BPP Form”). Larger businesses typically use insurer- or broker-specific forms that are more complex and, often, broader than the ISO forms. “ISO” is the acronym for the Insurance Services Office, Inc. that promulgates standardized insurance policy forms of various kinds. Large businesses may, as noted, use ISO forms but may also use “manuscript” policies. The terms and breadth of coverage of a manuscript policy is negotiated between the insurer and the insured.

Physical Damage to Covered Property

Under the ISO business interruption forms, the insured is covered for an “actual loss of business income” whenever an interruption of the insured’s commercial operations results from the “direct physical loss of or damage to property at the premises” named in the policy declarations of a first-party property policy. Under this or similar provisions found in other time-element coverage forms, business interruption coverage is typically limited to a loss arising from direct damage to the insured’s physical property, meaning that indemnity for time element losses under the policyholder’s commercial policy coverage is available only when damage resulting in substantial or material physical change to covered property occurs. This requirement of covered physical damage, which must result from a peril that the subject property policy covers, is generally treated as a condition precedent to coverage.

In other words, in order to recover, the policyholder must show that its business interruption claim resulted from something that the policy’s property insurance insuring agreement covers. The indemnity benefits are not normally payable if something other than what the policy otherwise covers resulted in the loss.

However, as is clear under the terms of most business interruption policies, the insured will be able to recover if the claimed loss of business income resulted from damage to covered property, caused by a covered peril. In addition, as discussed above, some extensions of business interruption coverage, especially under broker- or insurer-specific forms, go beyond the scope of the property damage insuring agreement.

For example, if the business interruption coverage includes “contingent business interruption” insurance, an insured can recover losses resulting from damage to another entity’s property.

Necessary Suspension of Operations

In addition to the requirement of showing physical damage to insured property, a commercial policyholder must demonstrate, in the words of the common ISO business interruption coverage form, that covered business interruption losses occurred when the physical damage to the insured’s covered property resulted in the “necessary suspension” of the policyholder’s operations. Because many business interruption claims involve a slowdown, rather than a complete cessation, of operations, the current ISO forms define “suspension” to include slowdowns resulting from a covered peril. Higher end commercial business interruption policies accomplish the same result by using the phrase “interruption, whether total or partial,” in the insuring agreement.

However, some courts have held, when the terms “suspension” or “interruption” stand alone and are undefined, that losses in business income are not covered unless the insured can show that the physical harm unavoidably caused it to cease operations for some period of time.

For example, an insured hotel owner could not recover for business interruption losses related to the operation of the hotel itself based upon a fire that occurred in and required the shutdown of an adjacent restaurant where the hotel itself, including all rooms within the hotel, were undamaged and remained open for business throughout the period.

Yet, keep in mind that because the terms “suspension” and “interruption” were undefined, an argument might be available to the policyholder that the court should construe them in a manner most favorable to the insured. A successful argument would require the insured convincing the court that the terms were ambiguous themselves or, because of the lack of definition, as applied to the facts of the occurrence.

Determining Damages

Once coverage is established for a business interruption loss, several principles guide the determination of covered damages. Initially, the policyholder must be able to demonstrate actual damages in the form of lost business income resulting directly from the covered loss. A policyholder who cannot show a loss, or whose claim is entirely speculative, may not be entitled to recover.

For example, a warehouse owner was not allowed to recover business interruption losses related to a partial suspension of its economic activity due to covered property damage stemming from damage caused by Hurricane Katrina where the insured had, in fact, been able to fully recoup the claimed shortfall in income upon its partial resumption of operations.

The reasonable expectations of the contracting parties is that the insured’s business interruption insurance is to place policyholders in the same position in which they would have been if the covered loss had not occurred. Thus, any calculation of damages that ignored the insured’s recoupment of the claimed loss separate from the insurance proceeds constituted a windfall for the policyholder and defeats the purpose of the insurance. Some courts have recognized that increased revenues following a catastrophe may not properly be characterized as making up for sales that would have occurred had the catastrophe not occurred but, instead, are reactions to the catastrophe and, therefore, not properly subtracted from the loss

Proving or providing the court or trier of fact with evidence sufficient to calculate the shortfall can present a challenge. Given the nature of most business interruption losses –replacement or indemnity for income that would have been earned had operation of the business not been interrupted – calculating damages for business interruption claims typically requires the insured to assemble evidence showing what its typical business earnings for the period of time in question would likely have been, including by reference to the insured’s historical sales figures. This method allows the court to estimate the lost income for the period of time that the insured’s operations were interrupted by the covered peril by looking to the insured’s actual income from the suspended commercial activity over a comparable period of time.

For example, where an insured oil refinery was forced to reduce most of its operations for a period of fifteen days due to covered fire damage to one of its cracking units, the court accepted as sufficient proof evidence of the refinery’s earnings for a similar fifteen-day period, which the court compared to the refinery’s actual earnings during the 15 days after the fire, to determine the shortfall and establish the insured’s actual damages recoverable as business interruption losses. The use of historical earnings or revenue figures in estimating the amount of the lost income for the period of indemnity coverage helps to ensure in many cases that the policyholder will indeed be made whole.

Courts typically will not allow recovery based merely on speculation as to what the insured’s income might have been or could have been had the interruption in business operations not occurred. Indeed, the primary challenge that a policyholder faces in proving up business interruption losses, especially for losses based on the interruption of operations of new businesses or product lines, is often in demonstrating that the amount of the actual loss is not speculative. This also can be particularly challenging where the claimed business interruption loss is related to a claimed failure to meet revenue expectations in some part of the business operations that was indirectly affected by the covered property damage.

For example, a retailer was not allowed to recover under a business interruption policy for a claimed shortfall in anticipated earnings caused by water damage to its merchandise where, although the direct property damage from the water was covered by the insured’s property policy, it could not prove the claimed shortfall with sufficient certainty.

Another important component of the lost income determination is identifying the specific time frame for which the insured claims economic losses related to the suspension or interruption of business operations. As the “time element” concept suggests, even where the insured can establish that it is entitled to coverage for its lost income under the terms of the policy, that coverage will generally respond only up to the point at which the insured can restore its normal business operations.

For example, under a business interruption policy provision limiting indemnity to the “length of time as would be required with the exercise of due diligence and dispatch to rebuild, repair, or replace” the damaged property, the insured was only allowed to recover for losses for the time period required for it to resume functionally equivalent operations at the same location – not, as the insured argued, the length of time actually required to rebuild the entire damaged complex.

Similarly, the extra time needed to make improvements to the property would normally not be part of the loss period. Certain resumption-of-operation clauses may, as a condition of coverage, also require that the insured reduce the resulting business interruption loss as much as possible by reasonably available means, including use of other facilities, existing inventory, or other sources of supply.

Finally, because many businesses do not return immediately to their pre-loss profitability when operations are restored (as in the case of a restaurant that is rebuilt after a fire and opens for business, but some time passes before customers return at their previous volume), many business interruption policies include “extended period of indemnity” insurance, which provides coverage for profits lost during a set period of time (often 60 or 120 days) after operations are restored. This can be a very valuable extension of coverage.

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