Applying the 'but for' test to wide-area damage (part 2)

Editor’s Note: The discussion upon which this series is based took place prior to the FCA test case ruling in the U.K. that challenged the Orient Express Hotels v Generali judgment on concurrent causation. With that in mind, viewpoints post-FCA ruling are noted as such. As the appeals process in the FCA test case unfolds, this perspective may prove useful, as will the information presented about the ‘but for’ test from the perspective of measuring indemnifiable business interruption loss.

The ‘but for’ test is a commonly used paradigm to determine the legal or proximate cause of an injury or loss. In cases of wide-area damage caused by hurricanes and other natural disasters, the ‘but for’ test often comes into play as there are often many factors at play when an insured suffers a loss under these circumstances.

As noted in part one of this series, the test goes something like this: But for “X” (the hurricane, the loss of power, the decline in tourism, etc.) would “Y” (property damage, food spoilage, decline in revenue, etc.) have occurred? When determining business interruption (BI) and property damage losses in the wake of a hurricane and wide-area damage, the ‘but for’ test can become quite complex.

What follows is based on the Insurance Industry Town Hall: Wide Area Damage and the But For Test.

The forensic accounting perspective: X, Y, Z

Joe Scarlato, president, international for Lowers Forensics, offered the following explanation of the forensic accountant’s role in addressing a claim like the one on Silly Island:

A lot is going on with the case of Silly Island and it’s important that we set ourselves up for success with a good request for information. Just like the Orient Express hotels case, with Silly Island there are so many intervening causes, different revenue streams and unique concepts that sometimes you have to interview the finance person or the risk manager and attain some information before you push out the request for information.

Especially in something this complex, you’d want to sit with the all-risk policyholder on both hotels and understand why Hotel New York is not as popular as Hotel California, what revenue streams or what seasonal activities could arise? The standard BI calculation is applicable and the policy will direct us along with our team of adjuster and legal representative, but it goes deeper than that with all of the sub-limits and different aspects of the claim. It is important to understand the revenue that is being claimed as lost, why that revenue may or may not be present before the loss, or historically trending toward a rise or a decrease.

The importance of the intervening cause

But more importantly, it’s understanding the impact of the intervening cause. For instance, if one of these aspects would increase revenue for food and beverage at the hotel, because there’s a hurricane in the area and the only restaurant open is Hotel New York, that food and beverage may be a leased restaurant or may be owned by the hotel. You would need to know that because just because there are bodies in the building doesn’t mean it generates revenue directly.

One of the things that I’ve seen in the past, which is a mistake, is to assume that the presence of guests at the hotel is always more profitable. Sometimes there are FEMA rates. Sometimes there are governmental rates after a hurricane and there may be a high occupancy rate but you may make an error in using a standard average rate from pre-hurricane (the but for) and you’re looking to calculate a hurricane revenue stream with the loss.

The biggest thing for us would be the request for information being accurate, taking all the data provided by the adjuster, and really corroborating the fact pattern and then establishing a baseline.

When it comes to intervening causes of X, Y, and Z, the Z factor is the most important aspect of any kind of loss when you’re looking at business interruption. This is because calculating baseline with and without loss and then calculating the BI is pretty standard, but proving a windfall or clawback, especially in the hospitality industry or hotels, you really need to look at industry-standard reports, regional properties and other revenue-bearing properties. What would have happened but for the loss. What would the hotel have done based on trends in that size of a hotel or in that region?

Given the recent FCA ruling, David Gardiner, CPA and senior vice president at Lowers Forensics International, had this additional bit of information to add to the above: “The recent FCA ruling, if upheld, will have a material impact on business interruption losses sustained during wide-area events. Prior to this judgment, a business interruption loss would be measured contemplating the net income that would have been earned if the covered cause of loss did not occur. This means that the wide-area event’s impact (pandemic or hurricane) on the local economy and the insured’s specific industry would be a factor in the measurement. If insurers are instructed to ignore the wide-area event altogether (ignore the pandemic or hurricane) it could potentially lead to paying for losses not contemplated in their policy.

“From my position in the claims process, this ruling may provide an insured with the incentive to find a coverage trigger in a wide area event and, if successful, ‘hit the jackpot,’ allowing a financial recovery that could be significantly higher than what they would have earned had they stayed open and not triggered the policy. In a time of historical hurricane seasons, civil unrest and a worldwide pandemic this ruling could become a very slippery slope for insurers.”

The attorney’s role: Facts first

“The most important thing, as far as I’m concerned, if I’m having to resolve any differences with the policyholder is the facts,” said Damian Cleary, managing director of DCThree Services, and acting as the insurer’s attorney for this claim. “I have to have the evidence. It is the most important thing.”

Two things are absolutely fundamental when addressing BI loss and causation, he said. One, the facts, but also two, its common sense.

The second thing, which proves to be hugely valuable in the current scenario when measuring and adjusting COVID-19 related losses, is engaging with the policyholder at very early stages. You get so much more information, facts, and evidence and, in my experience, the policyholder feels like they’re getting a response from their insurance company and they’re more likely to help and that hopefully will lead to non-adversarial dispute resolution.”

With the team gathered to resolve the claim on Silly Island, the questions become:

• Does the cruise ship recover for the loss of the cruise liner sinking?
• In theory, does wide area damage give rise to windfall profits?
• Is it true that the worse the insured event, the less the coverage?
• If the BI losses are presented individually under each extension, what does Hotel California recover for its BI losses?
• If BI losses are presented individually under each extension, what does Hotel New York recover for its BI losses?

Warren Marc Johnson is president of Lowers Forensics International. He has more than 30 years of forensic accounting experience and has handled damage valuations, insurance claims analyses, and litigation support throughout the United States and abroad.

The opinions expressed here are the author’s own.

The third installment in this series will look at consequential business interruptions stemming from wide-area damage claims. Review part one of this series.

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• A look back at 2020′s COVID-19 insurance coverage lawsuits
• Global insured catastrophe losses in 2020 fifth-costliest on record
• Top 5 challenges facing the insurance industry