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Time to examine coverage for Japan losses

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Faced with substantial losses due to the earthquake, tsunami and nuclear crisis in Japan, U.S. companies likely will look to their insurers to recover, say Laura A. Foggan and Jeremiah J. Galus of law firm Wiley Rein L.L.P. in Washington. Like other disasters, the events in Japan will give rise to important insurance coverage issues, particularly with respect to business interruption losses. Policyholders and insurers alike will need to examine the coverage, exclusions, conditions and limits of their policy as well as the facts of each claim, they say.

The ongoing tragedy in Japan is having a major effect on businesses. In addition to the tremendous human loss, the earthquake, tsunami and nuclear crisis in Japan have forced many companies, including Japanese companies and large, multinational corporations such as Bridgestone Corp., Canon Inc., Honda Motor Co., Panasonic Corp., Proctor & Gamble Co., Sony Corp. and Toyota Motor Corp. to suspend some, if not all, of their operations in the affected regions in Japan. Further, Japan's infrastructure, including transportation, utilities and communications networks, has been badly damaged by the earthquake and tsunami.

In addition, the damage to Japan's Fukushima Daiichi nuclear power plant has created a nuclear crisis, prompting the evacuation of nearby towns and cities and causing contamination of food and water supplies.

U.S. businesses already are facing a variety of consequences from these events, including disruption of supply chains resulting from the closure of facilities and plants in Japan as well as the U.S. Food & Drug Administration restriction on importing milk, milk products, fresh vegetables and fresh fruits produced or manufactured from the Japanese prefectures of Fukushima, Ibaraki, Tochigi and Gunma.

Because Japan must first respond to the immediate social and human toll, it may take longer to respond to the economic effects of the disaster. Businesses in the U.S. and elsewhere therefore likely will face prolonged shortages of raw materials or component parts as a result of transportation disruptions and manufacturing plants and facilities shutting down.

These business interruptions obviously have resulted in income losses for those companies. Moreover, with today's globalization of business and industry, companies across the world, including U.S. companies and insurers, will continue to feel the economic effects of shutting down these manufacturing plants and facilities and the anticipated shortage of raw materials or component parts.

Transportation delays and power shortages, as well as physical damage, have been cited as contributing to the plant closures as well as the existing and potential future supply chain interruptions and business income losses suffered by U.S. companies.

General Motors Co., for instance, reportedly has been forced to suspend operations of its Shreveport, La., pickup truck plant because of supply chain disruptions. Likewise, reports said Toyota announced that it expects to halt some North American production because of parts shortages stemming from the earthquake and tsunami.

Many other U.S. companies, beyond the automotive and technology industries and businesses dependent on them such as consumer electronics, aviation and medical device manufacturers, will face similar business income losses. For instance, U.S. food suppliers and consumers will be affected by the FDA's import alert. The principal importers of food products from Japan are the United States, China, Hong Kong and Taiwan.

Because of the economic climate, many businesses are unlikely to have maintained a substantial inventory, making them especially vulnerable to a supply chain disruption affecting materials and parts. Therefore, the shutdowns in Japan may rapidly affect U.S. and global business operations.

Faced with substantial losses, U.S. companies likely will look to their insurers to recover. As other recent disasters have done, the events in Japan will give rise to important insurance coverage issues, particularly with respect to recovery for business income losses. Insurers will need to evaluate claims carefully in light of the scope of insuring agreements, operation of exclusions, conditions and limitations in the policy, and the facts of each claim. There will also be new legal questions concerning the standards for recovery.

Commercial policyholders will rely on “business interruption” or “contingent business interruption” coverage in making a claim for recovery of their lost business income. While business interruption coverage addresses lost profits caused by damage to the policyholder's own property, contingent business interruption coverage addresses a policyholder's losses resulting from interruption of suppliers' or customers' business due to damage to their property. Many major firms have manuscripted property policies that include these coverages.

Experience from litigation after previous disasters makes clear, however, that many commercial claims for lost business income will be outside the scope of applicable coverage and/or the covered loss will be significantly reduced from the amount of the initial claim. Contractual limitations on commercial insurance agreements generally have been upheld in the courts, even when this means a policyholder may not recover from its insurance for a disaster's effects on its business operations.

As a threshold matter, the policies at issue may contain exclusions that preclude coverage. There can be no coverage for lost business income if the policy itself excludes coverage, even if the lost income resulted from damage to property. Cases that speak to this include the 1972 7th U.S. Circuit Court of Appeals ruling in Diamond Shamrock Corp. et al. vs. Lumbermens Mutual Casualty Co., in which the court ruled the insured was not entitled to recovery of its business interruption loss because the damage was caused by fire, a risk expressly excluded in the business interruption policy. In a 2004 ruling in City of Chicago vs. Factory Mutual Insurance Co., a federal judge ruled that there was no coverage for business interruption losses by Chicago's airports from the 2001 Federal Aviation Administration order to halt all flights because the policy excluded coverage for “indirect or remote loss or damage.”

In the Japan disaster, property damage and resulting business income losses could stem from the earthquake, tsunami and/or the nuclear crisis. Because many property policies contain exclusions for “acts of God,” floods, earthquakes and nuclear contamination coverage may be excluded on one or more of these bases.

However, some affected policyholders, particularly those with physical plants in Japan, may have purchased earthquake coverage by endorsement or otherwise.

In addition to the exclusions, there are other important policy terms that will determine whether coverage is available for claims for business losses. A key point is that, as courts nationwide consistently have recognized, a covered damage to or loss of physical property is necessary for coverage to exist. For business interruption coverage, the damage must be to the property of the insured or, for contingent business interruption coverage, to the property of a supplier or customer.

Losses may result from embargos, logistical difficulties or other circumstances that do not constitute damage to or loss of physical property. A leading ruling on this point is the 2006 decision by the 8th U.S. Circuit Court of Appeals in Source Food Technology Inc. vs. U.S. Fidelity & Guaranty Co., which established that there was no “direct physical loss to property” within the meaning of “business income” or “action by civil authority” coverage provisions when an embargo against Canadian beef rendered beef purchased by the policyholder unshippable to United States even though the beef was not contaminated or damaged in any way.

Accordingly, insurers should carefully consider whether the interruption of a policyholder's business was caused by property damage, as is required in widely used insurance policy terms, or by some other circumstance or action associated with the events in Japan that may or may not be insured.

Because of restrictions affecting people in the affected Japanese prefectures after the earthquake, tsunami and subsequent nuclear crisis, some commercial policyholders may look to the civil authority provisions in their policies for lost income and extra expense coverage. Policyholders might further look to ingress/egress provisions in their policies for coverage. Civil authority provisions may cover loss of business income and necessary extra expenses caused by civil authorities prohibiting access to the insured premises, whereas an ingress/egress provision may cover loss of business income when access to the policyholder's premises is prevented.

Civil authority coverage has important prerequisites, however. A very recent decision speaks to this point. In the March ruling in Dickie Brennan & Co. Inc. vs. Lexington Insurance Co., the 5th U.S. Circuit Court of Appeals said, “The general rule is that civil authority coverage is intended to apply to situations where access to an insured's property is prevented or prohibited by an order of civil authority issued as a direct result of physical damage to other premises in the proximity of the insured's property.”

Similarly, in the 2003 5th Circuit ruling in Bienville Partners Ltd. vs. Assurance Co. of America, the appeals court said the FAA's closure of airports after Sept. 11, 2001, did not “prohibit access” to the policyholder's hotels as required under the clause and the FAA did not “prevent” customers from going to the hotels. Another ruling on this point, the 2003 New York Supreme Court Appellate Division decision in 54th St. Ltd. Partners L.P. vs. Fidelity & Guaranty Insurance Co., said “vehicular and pedestrian traffic in the area was diverted, (but) access to the restaurant was not denied,” meaning no recovery for the policyholder.

Here, restrictions on the use of roads ordered by Japanese authorities would not give rise to civil authority coverage unless they specifically barred access to the property. Similarly, an ingress/egress provision does not afford coverage if access to the insured premises is still possible.

Policy terms and case law also put important boundaries on the damages that are recoverable and the period of restoration of business operations in business interruption coverages. For instance, in the 2003 New York bankruptcy court ruling in Duane Reade Inc. vs. St. Paul Fire & Marine Insurance Co., the court ruled that the “restoration period” limitation on business interruption coverage ended when a store that was destroyed by the 2001 terrorist attacks “could resume functionally equivalent operations in the location where its (World Trade Center) store once stood.” Cases from earlier disasters illustrate how disputes about legal standards will have as much or greater impact on the extent of covered damage as will investigation and determination of the facts.

In many cases in the current Japan situation, large multinational corporations will have manuscripted or special policies written to address risks inherent in specific business settings.

Endorsements for power interruptions, earthquake coverage and unique wordings may be at issue. Even in these settings, there will be important parameters on the coverage provided that must be reviewed as insurers receive, investigate and process claims arising from the disaster in Japan.

Insurers will play an important role in the recovery from this crisis and need to investigate, process and pay valid claims from a wide variety of policyholders. Although many business losses will be insured, there also are important limitations on the scope of coverage afforded for business interruption and contingent business interruption losses that are fundamental to the insurance system.

Laura A. Foggan is chair of the insurance appellate group at Wiley Rein L.L.P. in Washington, handling complex insurance claims and counseling insurers on emerging exposures. Ms. Foggan, who has participated in more than 200 insurance coverage appeals nationwide, can be reached at 202-719-3382 or lfoggan@wileyrein.com.

Jeremiah A. Gallus is a lawyer in Wiley Rein's insurance practice, focusing primarily on representing insurers in complex coverage litigation. He can be reached at 202-719-7112 or jgalus@wileyrein.com.