Catastrophic Events Raise Business Interruption Coverage Questions

Considering the number of people who lived and worked in the area, the destruction of the World Trade Center complex was the functional equivalent of obliterating a small- to medium-sized city.

Several recent and relatively recent events — the wildfires in southern California, Hurricane Katrina in August 2005 and the Sept. 11, 2001, terrorist attacks — have raised awareness of how and whether business interruption (BI) insurance applies in the context of a regional or widespread catastrophic event. The scope and reach of these events magnify the two central questions underlying BI insurance: How is lost revenue calculated following the catastrophic event, and how long does coverage run? While both issues are important, this article will only address the time period over which an insured can collect BI insurance following a widespread catastrophic event. ⁽¹⁾

Disruption From Widespread Cat Events

Business interruption insurance is generally a component of property insurance or a business owner’s policy, and is intended to replace the revenue stream lost due to the interruption of business caused by damage to the insured property. However, in a widespread catastrophic event, the duration of the interruption can be greatly magnified compared to localized events.

Considering the number of people who lived and worked in the area, the destruction of the World Trade Center complex was the functional equivalent of obliterating a small- to medium-sized city. Hurricane Katrina did obliterate many small cities and substantially devastated the major American city of New Orleans, La. The recent California wildfires destroyed thousands of acres of land and numerous homes. Those events displaced thousands of people and businesses, and it is far from certain when or if the affected areas will return to their pre-catastrophe condition.

Because of the magnitude of damage caused by those events, a business could find that it can be physically rebuilt or relocated but still be unable to return to its former profitability due to the loss and/or destruction of the surrounding community. Businesses located in the World Trade Center before Sept. 11, 2001, cannot be rebuilt as before until the World Trade Center is rebuilt, and it is questionable whether they can relocate to a comparable property. While the businesses in the area surrounding the World Trade Center site can be rebuilt, the absence of the World Trade Center significantly diminishes their market. Similarly, businesses in the areas devastated by Hurricane Katrina and the California wildfires may rebuild only to find themselves standing alone in a now unpopulated area that was once thriving.

Such circumstances raise the question of whether those business can collect BI insurance until the immediate market recovers (subject to any maximum time limitation contained in the policy), regardless of when or whether the business itself is rebuilt or relocated. From a business standpoint, the impact of those events may well be permanent because of changes in population concentration, population size and the demographics of the remaining or returning population. Because those changes happened virtually overnight with little or no forewarning, the local businesses had no opportunity to react to a changing marketplace over time.

Prior to those catastrophic events, most of those business owners likely gave little or no thought to BI insurance or how it might apply in a major catastrophic event. However, given the ongoing buildup of cities in areas subject to major natural disasters, such as hurricanes, floods, wildfires and earthquakes, these considerations are neither academic nor limited to particular regions of the United States.

How Long Can a Business Owner Collect?

This question of how long a business owner can collect BI insurance following a widespread catastrophic event has been addressed in several cases arising out of the Sept. 11 terrorist attacks. The cases indicate that absent particular policy language, standard BI coverage will not run until a business regains its former market or profitability. The language of many BI policies speaks of providing BI coverage during the “period of restoration” of the damaged property. The “period of restoration” is understood to be the theoretical time required to reasonably repair the damaged property and return the business to operation.

Following the Sept. 11 attacks, several business owners argued that the “period of restoration” for their BI coverage should be the time required to return their business to operation in an environment comparable to that existing at the World Trade Center complex.

While undoubtedly sympathetic to the business owners, the courts generally rejected the notion that the “period of restoration” runs until the business is restored to the same sales environment, profit earning potential or “functionally equivalent operations.” In short, unless the policy coverage was specifically tied to the World Trade Center property, the courts concluded that the BI coverage ceased once the business could be, or should have been, repaired and operations resumed. ⁽²⁾

One court acknowledged that the “period of restoration” runs until a reasonably equivalent building could be constructed in a reasonably equivalent location, but made it clear that a “reasonably equivalent” location means something far less than the identical or even a comparable location, stating:

“In sum, we hold that the St. Paul policy does not provide BI coverage until Duane Reade can resume operations in the store located at its former WTC site. Instead, coverage extends only for the hypothetical time it would reasonably take Duane Reade to ‘repair, rebuild or replace’ its WTC store at a suitable location. To be sure, there are few, if any, locations in New York City comparable to the WTC, and Duane Reade will most likely not be able to recreate the profit stream it once enjoyed there.” ⁽³⁾

Although there have been no reported decisions involving BI coverage claims resulting from Hurricane Katrina, there is no reason to expect a different result, absent specific policy language to the contrary. Indeed, attempts to extend coverage under BI policies for Hurricane Katrina related losses are likely to face additional obstacles. Property insurance policies typically exclude losses caused by flood and a significant amount of the property damage in the areas affected by Hurricane Katrina were caused by flooding. Even assuming a business in the Gulf Coast region could establish its business was interrupted by a covered peril caused by Hurricane Katrina, such as wind rather than flooding, the business owner would probably have a difficult time establishing that for business purposes, the surrounding locale was no longer equivalent to the pre-hurricane locale as a result of some cause other than flooding.

Other Available Coverages

A significant factor in the court rulings on the Sept. 11, 2001, BI claims was the existence of other forms of BI coverage. The two coverages most appropriate to business interruption as a result of a widespread catastrophe event are extended coverage provisions and contingent business interruption (CBI) insurance.

Generally, extended coverage clauses provide continuing BI coverage for losses suffered by the business after its damaged property is repaired. The overall scheme is that standard BI provides coverage for losses from the time of physical damage until the theoretical or actual time when the property is reasonably repaired, usually whichever is shorter; the extended BI coverage kicks in and covers losses continuing after repairs until the time when either the business has returned to its pre-damage levels or a set period of time specified in the policy, usually 12 months, has run, whichever is shorter. ⁽⁴⁾

Contingent BI insurance, by contrast, provides coverage when an insured’s business is interrupted by damage to property owned by some third party. Perhaps most commonly, CBI provides coverage for damage to the property of a critical supplier or vendor of the insured. However, there are different types of CBI coverage that may be available. For example, there is “leader” or “attraction” property CBI, which provides coverage for damage to another business entity or property that attracts customers to the insured’s business. However, it is not clear that any CBI coverage exists that would broadly cover the loss of business resulting from a general decrease in population or change in demographics caused by a widespread catastrophic event that reduces a business’ market rather than causes damage to specific property.

An Increasing Probability

Given the increasing probability of widespread catastrophic events in the future, it would be wise for agents with clients whose businesses are located in areas subject to such catastrophic events, or rely on businesses or customers in areas subject to catastrophic events, to review BI insurance coverages with their customers. To achieve the maximum coverage available in the event of a widespread catastrophic event, insurance agents or brokers should discuss with their vulnerable clients the value of supplementing their standard BI coverage with extended BI coverage and CBI coverage.

⁽¹⁾ For a more detailed discussion of both questions and other potential issues, see “Business Interruption Loss in the Wake of Katrina: Measuring the Insured’s Loss in a Volatile Economy,” 41 Tort Trial & Ins. Prac. L.J. 857 (Spring 2006), and Now “What Do We Do? Time Element Claims Following A Megaloss,” 34 WTR Brief 38 (Winter 2005).
⁽²⁾ Duane Reade Inc. v. St. Paul Fire & Marine Ins. Co., 411 F. 3d 384 (2nd Cir. 2005); Children’s Place Retail Stores v. Federal Ins. Co., 829 N.Y.S. 2d 500 (N.Y. App. 2006); Royal Indemnity Co. v. Retail Brand Alliance, 822 N.Y.S. 2d (N.Y. App. 2006); Retail Brand Alliance, Inc. v. Factory Mutual Ins. Co., 489 F. Supp. 2d 326 (S.D.N.Y. 2007); Streamline Capital, L.L.C. v. Hartford Casualty Ins. Co., 2003 WL 22004888 (S.D.N.Y. 2003); SR International Business Ins. Co. v. World Trade Center Properties, 2005 WL 827074 (S.D.N.Y. 2005)
⁽³⁾ Duane Reade, 411 F. 3d at 398.
⁽⁴⁾ Duane Reade, 411 F. 3d at 393-4. See also Lava Trading, Inc. v. Hartford Fire Ins. Co., 365 F. Supp. 434, 443 (S.D.N.Y. 2005).