Self Interest vs. Consistent Approach

The logic of a policyholder or insurance company can be viewed as suspect when the position it takes plays to its benefit. For example, some insurance companies argued that the general economic conditions should not be taken into account after Hurricane Andrew struck, with policyholders taking the opposite view. After 9/11, some policyholders argued that general economic conditions should not be taken into account, with insurance companies taking the opposite view. The difference was that after 9/11, the New York economy suffered a downturn, whereas after Hurricane Andrew, impacted regions enjoyed an economic windfall due to increased business from relief workers, insurance professionals, not to mention homeowners and businesses with insurance proceeds in hand.

In the case of the Gulf Coast losses during the hurricane season of 2005, economic data cut both ways, depending on the locale. In areas devastated by the hurricane that still remain depopulated, the economic loss, considering the subsequent economic conditions, would show no loss of income to businesses since there are no customers left in the impacted areas. Therefore, had a business suffered no loss and could open its doors for business the month after the storm, there would be no customers to serve and no income to be made. In areas suffering moderate damage, any business that could open its doors had a windfall of business, due to lack of competition and the influx of relief workers, construction, and insurance professionals. That means a consistent use or non-use of subsequent economic data for the 2005 hurricane season losses along the Gulf Coast would result in both higher and lower business-interruption amounts than should otherwise be considered lost.

It makes good sense to suggest some guidelines that would enable a more consistent approach regardless of who may benefit. Accountants typically use a but-for analysis to quantify a loss. In this type of analysis, one projects what the results would have been had no loss occurred. A key issue in setting up the but-for analysis is to determine what the insurance policy means by the word loss. Is the measurement restricted to the narrow loss suffered by the insured? Or is it a broader loss caused by the impact of the event itself to the entire geographic region?

The Island Theory

Hurricane Andrew was the first time many claim professionals had experienced a disaster event that impacted the region in which the disaster occurred. One actual case from Hurricane Andrew laid the groundwork for how to calculate claims according to the Island Theory.

In the midst of all the devastation in South Florida, one large national retailer's store amazingly was not significantly damaged and was open for business relatively quickly, long before many of its competitors. Quite naturally, people and businesses that suffered damage to their properties and were eager to buy emergency supplies and other merchandise flocked to this location. The store's sales skyrocketed far beyond pre-event projections and made the retailer, quite literally, a retail oasis amidst the devastation.

The Island Theory suggests that the coverage and but-for measurement should assume a business was undamaged and all the others around it, including its competitors, were damaged. The business, therefore, would be able to claim a portion of any unanticipated uplift in the post-event economy. The retail sector, for example, often experiences a boom in sales after property disasters, as homeowners and commercial businesses purchase replacement building materials, furniture, clothing, etc. This theory, though, restricts the definition of the loss to that specific business' loss. In other words, the loss or damage, whose impact the accountant should ignore in the but-for analysis, is the damage to the national retailer's store. Clearly, the damage to this particular store did not require thousands of relief workers to come to its city. However, the event causing the damage to the store resulted in thousands of relief workers coming to the city.

Variations of the Theory

The situation in which a retail establishment is damaged and repairs will take a number of months to complete, however, is less clear-cut. Should the policyholder be allowed to keep at least some of any post-event uplift? Say, equal to its pre-event market share it was unable to generate?

Judge Hall, of the 4th U.S. Circuit Court of Appeals, stated the situation clearly in his dissenting opinion for Prudential v. EconoLodge (1992 U.S. App. LEXIS 25719):

“The majority persists in framing the issue as what the motel's situation would have been had the hurricane not occurred at all. However, the contract states that 'due consideration' be given to pre-damage earnings and 'the probable earnings thereafter, had no loss occurred'. [The phrase] 'had no loss occurred' does not refer to the overall loss in the surrounding area; rather, it clearly refers only to the loss incurred by the insured. The parties stipulated that, had the motel not been put out of commission by Hurricane Hugo, the motel would have realized a profit of $192,000 in the months after the storm.

“The majority acknowledges that proof of an imminent general economic up-turn, or of a lost-profit opportunity thwarted by the loss-causing event, can justify recovery under a lost-earnings provision. I assume, then, that had the motel been destroyed by an isolated fire the day before Hugo hit, the majority would rule that lost profits would have been recoverable because the cause of the property loss (the fire) was not the same as the cause of the profit opportunity (the storm). Similarly, if gold were discovered the day after Hugo and the entire region filled with gold seekers (as well as relief workers), I assume that lost profits would be covered. Although Hugo caused both the property loss and created the profit opportunity, it does not strike me as an 'intuitively-sensed logical flaw' to permit recovery under these circumstances.”

This dissenting opinion clearly highlights the dilemma that occurs when the cause of a loss, not the specific covered loss paid for by a particular insurance policy, is also the cause for changing economic conditions after the loss. Judge Hall analyzed the policy language to determine if the contract defined the loss as the generalized loss that impacted the economy, or the actual property damage loss paid for under the policy, which did not impact the economy.

Looking at several pertinent clauses of a typical policy's business-interruption coverage can guide our response to the questions posed above. These clauses are not exact quotes from any particular forms but are an amalgamation of similar clauses from various policies. Of course, not all policies contain identical language. That is why it is very important to read and understand the language in the specific policy with which you happen to be dealing. The following is a basic insuring clause:

This policy insures business-interruption loss as defined directly resulting from physical loss or damage of the type insured by this policy to property: described elsewhere in the policy and not otherwise excluded by this policy; utilized by the insured; located at an insured location; and during the period of liability described in this policy.

We can seek guidance from the following phrase, which is similar to clauses included in many commercial insurance policies: Due consideration shall be given to the experience of the business before the date of loss or damage and to the probable experience thereafter had no loss or damage occurred. The experience of the business before the loss is easy to discern in various ways. One way is to compare the actual results with projections for similar periods over time. Then reasonable conclusions can be drawn about what likely would have occurred but for the loss or damage to the stores.

But is that enough? Should not the probable experience after the loss also consider increases in the post-event economy caused by the hurricane event? Isn't it reasonably probable that if a hurricane hit South Florida with the magnitude of Andrew, an economic uplift in the retail sector would occur as homeowners and businesses began to replace their damaged properties after receiving insurance proceeds? If the regional economy had simply tanked after the event, might insurers likely consider that as a mitigating factor in responding to an insured's business-interruption claim calculation as they did after 9/11? Then why would it not be reasonable to consider the uplift?

No Loss or Damage

The phrase “Had no loss or damage occurred,” which appears in several of the clauses, can be read to mean, “Had no loss or damage occurred to my property (but the disaster event still caused the damage around me).” However, another broader, more generalized meaning could be “Had no loss or damage occurred to anyone,” which, in effect, means, “Had no disaster event occurred.”

The first, narrower interpretation supports a reasonable argument for including the uplift in the business-interruption loss. It suggests that our retailer ought to be able to claim, in addition to any shortfall against its pre-loss projections, the amount of the post-event uplift equal to its pre-event market share that it was unable to achieve due directly to its physical damage. The broader interpretation suggests the opposite; that the retailer can claim only what it could have sold if the disaster event had not occurred. In other words, our retailer would be permitted only to recover what it could reasonably support without considering post-event economic conditions.

As each business-interruption policy's language can be slightly different from that above and one another, it behooves both sides to study the words in their specific contracts before drawing liability conclusions and drawing lines in the sand.

A Simple Solution?

One of the many important lessons learned is that explicit language dealing with the post-event economy can prevent significant conflict over business-interruption claims. Such language may read similar to this:

Regional Economic Impact: In no event will this policy pay for any increase in business-interruption loss occasioned by the impact of the event upon the economy of the region where it occurred.

When this phrase or one similar to it is contained in the business-interruption forms, it would be much more difficult for a policyholder to expect to recover a share of post-event uplift. If an insurance policy does not contain a clause such as this, and where the impact of considering post-loss economic conditions is material, it would be wise to seek the opinion of coverage counsel.

Michael LoGiudice and Steven Kessler are directors of advisory services, dispute analysis and investigations, for PricewaterhouseCoopers. LoGiudice is located in the firm's Chicago, Ill., office, while Kessler is based in Houston, Texas.