Applying the 'but for' test to wide-area damage (part 3)

Editor’s Note: As we conclude our series on wide-area damage, it’s important to note that 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.

Wide-area damage, consequential BI losses

This paper reiterates and reflects upon the Town Hall discussion arranged by Lowers Forensic International on 5 August — the recorded webinar can be found here.

Which is the proximate cause of the sinking of the ship in Figure 1 (above): (i) the torpedo which strikes first; or (ii) the perils of the sea from the approaching hurricane, as stormy seas could sink the damaged ship?

Concurrent Causation

What if the causes of the sinking of the ship happened concurrently (at the same time) i.e., the torpedo hits as the ship is foundering in heavy seas? It depends on the efficiency of each cause, which is a factual question.

(i) Interdependent Causes

• If neither the heavy seas nor the torpedo is sufficient to sink the ship by themselves, but both together are sufficient, each of them is “interdependent” causes of loss. The loss would not have occurred without both causes operating.
• If the insurance policy expressly covers loss for perils of the sea (hurricane) and is silent as to an act of war (torpedo), the insurance policy responds. If the insurance policy expressly covers loss for perils of the sea (hurricane) but expressly excludes acts of war (torpedo), there is no insurance cover.

(ii) Independent Causes

• If each of the heavy seas and the torpedo is sufficient to sink the ship by themselves, each of them is an independent causes of loss. The loss would still have occurred without both causes operating.
• The difficult question: which peril, or cause of loss (hurricane or torpedo), is responsible for sinking the ship?
• But for the hurricane, what would have happened to the ship? It would have sunk because of the torpedo.
• But for’ the torpedo, what would have happened to the ship? It would have sunk because of the hurricane.
• Which is the proximate cause of loss: neither (unfair to the policyholder) or both (unfair to the insurer)? English contract law says neither and this apparent unfairness on policyholders has generated academic criticisms of the judgment in Orient Express Hotel.

Application to BI losses and the ‘but for’ test

Most property/BI insurance policies insure business interruption losses on the following basis:

“If any property owned used by the insured for the purpose of or in the course of the business suffers damage as insured by this policy (or there occurs an event or circumstances as insured elsewhere in this section of the policy which is deemed to be damage) and the business be in consequence thereof interrupted or interfered with the insurers will pay to the insured the amount of the loss resulting from such interruption or interference.

The loss as adjusted shall represent as nearly as may be reasonably practicable the results which but for the damage would have been obtained during the relative period after the damage.” (Emphasis added.)

The insured peril in such a standard property policy is “damage.” To measure the indemnity for consequential BI losses resulting from such damage, the ‘but for’ test is used.

In the case of a major catastrophe, which causes widespread damage over a wide area, the appropriate measurement test (or counterfactual) is: How much revenue/profit would the insured business have obtained had the insured premises not been damaged? Putting it another way, and as confirmed in Orient Express Hotels, what would an undamaged hotel have earned in an otherwise damaged city?

The rationale behind this decision is to indemnify the insured for what was purchased, no more and no less. The insurance policy was to indemnify for (i) physical damage to insured property and (ii) consequential loss of revenue resulting from such physical damage.

To ensure that the indemnity is for no more than was bargained for, it is necessary to identify the peril insured against which the policy has been priced. As the Arbitration Tribunal said in Orient Express Hotels: “The fact that there was other damage which resulted from the same cause does not bring the consequences of such damage within the scope of the cover.”

And, on appeal to the High Court, the judge said: “What is covered are business interruption losses caused by Damage, not business interruption losses caused by damage or ‘other damage which resulted from the same cause.’”

The counterfactual in Orient Express Hotels is “had the damage not occurred”; not “had the damage and whatever event caused the damage not occurred.”

Is Orient Express Hotels wrong?

Damage usually occurs in a readily identifiable way e.g. the effects of fire, wind, flood, and earthquake, for example, on tangible property. That is why all-risk insurance policies do not identify the countless events or causes which give rise to damage insured against. And, it is for this reason that the main insuring clause in such policies state: “In consideration of the Insured paying the premium the Insurers agree to indemnify the Insured under the Material Damage Section against direct physical loss, destruction or damage except as excluded herein to Property as defined herein such loss destruction or damage being hereafter termed Damage.”

On the other hand, BI losses require a more forensic examination because their cause (or causes) are not so readily identifiable. Hence the requirement of a counterfactual and the application of the ‘but for’ test.

Whilst the judge in Orient Express Hotels did not think “an inquiry into actual motives” of cancellations and reduced revenue was required in that case, the nature of other insured perils often found in property/BI policies would require such inquiries. These “other” insured perils are “non-damage” extensions of cover.

As stated above, where there is physical damage, the trigger of consequential BI losses is easily identifiable. For example, if a restaurant is burned to the ground, there are no premises in which diners’ revenue can be generated, and the necessary counterfactual for BI loss calculation is a relatively easy concept to grasp.

Where there is more than one cause of loss in a “damage” scenario (as in the case of Orient Express Hotels, where the hotel had suffered some damage, and the City of New Orleans was also underwater), an inquiry into people’s motives starts to become relevant.

But where there is no damage, it is not so easy to identify the elements of the counterfactual and it is, therefore, necessary to inquire why a diner (in the restaurant example) chooses not to visit the restaurant. And this requirement is even more of a necessity where there may be more than one (concurrent) cause of a reduction in revenue (or motives).

Returning to the difficult question of identifying the cause of loss where there are concurrent independent causes of loss, how likely is it that our imaginary diner’s decision not to visit a restaurant gives rise to the difficult question? There are two potential causes of loss behind the diner’s decision not to visit the restaurant:

1. Fear or threat to personal safety as a result of COVID-19; and/or
2. Government regulations requiring the closure of the restaurant.

Recalling that proximate cause is the dominant or efficient cause, which of the motives is the dominant one? There can only be concurrency of causes if each was equally dominant, but how likely is that? Can you imagine potential diners asking themselves: “I am not going to the restaurant because I fear for my safety and because it is closed, but I cannot decide which of those reasons over the other is the main reason?” It is very unlikely, indeed. There is no “absurd result,” as was argued by the FCA.

Therefore, there is no unfairness or difficulty in applying the’ but for’ test in the circumstances of the current COVID-19 pandemic.

One major criticism of applying the ‘but for’ test when assessing the appropriate counterfactual and measuring the indemnity for BI losses in any particular case is the perception that the more serious the circumstances that give rise to the losses, the less insurance cover there is available. This is one of the “absurd” results relied on by the FCA. The court stated: “If the correct construction of the policy compelled the conclusion advocated by [Generali] that would be one thing, but, standing back, it seems inherently unlikely and counter-intuitive that the cover provided was illusory.”

The cover provided to the hotel was not, in fact, illusory. The hotel had purchased cover for the wider and devastating effects of the hurricanes (loss of attraction and denial of access), but such additional covers were sub-limted to $500,000 per event. Therefore, the hotel was entitled to recover for BI losses caused by damage to the premises (where potential guests could not have been accommodated because of the damage), and $500,000 per event for each loss of attraction (where potential guests chose not to travel to New Orleans because it was under water) and denial of access (where potential guests could not, in fact, get to New Orleans because of the devastation to the city’s infrastructure). Why is it, therefore, that when investigating the correct counterfactual, all of the consequences of the very event or fortuity that caused the insured damage (and consequential BI losses) should be accounted for so that the test is one of “but for the hurricane” rather than “but for the damage” as expressly set out in the insuring clause?

Leaving aside the High Court’s acknowledgment that Orient Express Hotels was perhaps decided correctly if a “correct construction of the policy compelled” such a decision, the argument that the greater the devastation to the surrounding area, the less indemnity is afforded simply does not arise. If there were no sub-limits to the extensions of cover for the wider effects of the hurricane, a full indemnity will have been given.

As a result of this apparent misunderstanding of investigating and measuring the appropriate counterfactual, the High Court in the FCA Test Case has rendered the inclusion of business interruption extensions in catastrophic situations as meaningless. If the correct counterfactual in Orient Express Hotels should have been but for the damage caused by the hurricanes, the hotel would have recovered all of its BI losses because the but for test would have stripped out the wider effects of the hurricanes. That is directly contrary to the findings of the Arbitration Tribunal and the High Court judge on appeal, which said: “That would measure the gross operating profit which would have been made by Orient Express Hotels if the hurricanes had not struck at all and would therefore compensate Orient Express Hotels for all business interruption losses howsoever caused, even where those losses were not in any way caused by Damage (and as such are not recoverable under the main Insuring Clause of the Policy).”

To get around this obvious difficulty, and so distinguishing the FCA Test Case with Orient Express Hotels, the Court interpreted an “insured peril” differently when assessing compound or composite clauses. Very many of the relevant non-damage business interruption clauses assessed in the FCA Test Case provided cover for interruption or interference with the business as a result of:

• Access to or use of the premises being prevented or hindered
• by any action of government or a local authority
• due to an emergency, which could endanger human life or an outbreak of infectious disease at or in the vicinity of the premises.

All three elements (or compounds/composites) make up the insured peril and, therefore, all three elements have to be stripped out when assessing the “but for the insured peril” counterfactual. While that may well be a correct exercise in the mechanics of measuring BI losses in the case of such a compound/composite clause, why does that render the judgment in Orient Express Hotels as wrongly decided? With the greatest of respect to the court in the FCA Test Case, it doesn’t, particularly when the court concluded that its interpretation of an insured peril in compound/composite clauses was any different: “Nothing in Orient Express dictates a different conclusion.”

In conclusion, Orient Express Hotels was not “wrongly decided” and, instead, was “simply not concerned with the type of insured perils involved” in the FCA Test Case. The ‘but for’ test of “an undamaged hotel/premises in an otherwise damaged city/environment” remains good law and remains the appropriate measurement of indemnity for catastrophic damage situations.

Damian Cleary is managing director for DCThree Services and is known for his ability to handle insurance and reinsurance matters for the Lloyd’s and London markets.

The opinions expressed here are the author’s own.

This is the third installment in this series. Review part one and part two of this series.

Related:

• 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