In the aftermath of the US hurricanes, business interruption has become a topical issue, but it is often misunderstood Ling Ong, Catherine Rawlin and James Stanbury consider some of the legal and practical accounting issues arising after a major catastrophe.

Putting aside questions of extensions to the cover, in most cases four conditions need to be met for there to be a valid claim under a business interruption (BI) policy:

1. Loss or damage by one of the insured perils;

2. Occurring at premises used by the insured for the purpose of the business;

3. Causing interruption of or interference with the business carried out by the insured at the insured premises; and

4. A material damage policy in place that covers the interest of the insured in the relevant property.


Insured peril

An obvious point, but BI cover only responds to losses caused by an insured peril. This fundamental issue is currently the source of many post-Katrina disputes in cases where it is alleged that insurance policies covered storms but not flood damage. A related point is that the cause of the loss must not be excluded by policy terms. One aspect of English insurance law that is often not fully appreciated is that, if there are two causes of a loss, one which is covered by the policy and the other which is excluded, the insured will have no claim.

A recent example of this was Midland Mainline Ltd v Eagle Star Ins Co Ltd [2004], which arose out of the Hatfield rail disaster in the UK. The derailment resulted from a broken rail caused by a rolling contact fatigue. After the crash, Railtrack imposed emergency speed restrictions on all sites where rolling contact fatigue was known to exist. Midland Mainline claimed under a "denial of access" extension to its BI cover. The Court of Appeal, however, found that there were two proximate causes of the damage; the rolling contact fatigue and the speed restrictions. The speed restrictions fell within the cover, but the rolling contact fatigue fell within a wear and tear exclusion. The insurance claim therefore failed.

Damage at premises

BI polices generally require material damage to have been caused to the insured's property at the premises. Physical damage, however, inevitably brings its own practical problems. Frequently, some or all of a company's documents will have been destroyed by the catastrophe. Picking up the document trail from less direct sources is likely to require considerable ingenuity and time. Computer back-ups, advisers (such as banks or accountants), customers or suppliers, tax authorities, company filings, market/industry statistics or (in the Katrina example) Federal Emergency Management Agency claims may all prove useful. But some or all of these other sources may also be suffering the effects of the disaster. Even if they are not, they are probably being deluged by similar requests.

Some BI polices extend cover to include losses arising out of damage to other property even when the insured's property is not affected. Denial of access cover (as in the Midland Mainline case) is one example. Another is contingent business interruption insurance (CBI), which covers interruption to the insured's business caused by loss or damage to premises belonging to third parties on whom the insured's business depends, such as suppliers, sub-contractors or customers. Linking cause and direct effect is even more critical in CBI claims, where the loss flows from damage to the "dependent property". Most CBI coverage requires that the cause of the damage is one that would be covered under the insured's own property cover, had it occurred at its own premises.

A further example is leader property cover, where an "attraction" property that is key to an insured's business (but separate from it financially) suffers physical damage. Such losses were prevalent after 9/11 and the destruction of the World Trade Center. When considering cause and effect, however, commonsense must prevail. A downturn in earnings in a chain of stores across, say, the whole of the US is less likely to be considered recoverable than losses from a set of stores within a more moderate distance of the leader property.

Catastrophes will have a far more detrimental effect on the rate of recovery of the sales of a business than a "normal" loss. Supplies may be interrupted as a result of damage to roads, bridges and other infrastructure. Staff cannot travel to work because they are dealing with damage to their own property, injury or the same lack of infrastructure (it is estimated that there were some 67,000 workers within 100 miles radius of Katrina's path). Customers may be similarly affected. Contractors undertaking repairs will be stretched to their limits and may be called on to focus on specific projects. All of these issues complicate the often already difficult task of identifying the losses arising directly from a particular covered peril.

A widespread disaster will also affect the insured's future market for some time, whether or not the insured's property was damaged. Hotels near a disaster area, for instance, can all suffer a downturn in demand. In calculating the BI loss, the insured's forecasted sales may need to be adjusted to take into account the likely negative impact that would have occurred in any event. The indemnity period Further issues concern the indemnity period. A fairly standard indemnity period in an English BI policy will begin with the occurrence of the damage and end "when the results of the business cease to be affected in consequence of the damage but not exceeding the maximum indemnity period." The maximum indemnity period, often 12 months, is then separately specified. On this wording, the indemnity period does not end when the business resumes normal trading activities, but (subject to the maximum period) when the results of the business are restored to normal, which may be some time after the physical damage has been made good.

Contrast the position with some US wordings, which refer to the date "when the premises should be repaired, rebuilt or replaced with reasonable speed and similar quality". What happens if, before the indemnity period following one incident is completed, a second incident takes place? Do you try to apportion the losses after the second incident as between the two, or do you treat the two incidents as separate, or is the second caused by the first so that in reality, there is only one incident?

Take, for example, a landslide at a railway embankment. Following the incident, the insured undertakes remedial repairs, but they are carried out negligently and a second landslide occurs. On one argument, the second landslide would not have occurred "but for" the first, so it was a direct consequence of the first and the BI should be treated as flowing from the first landslide. Another argument is that the second landslide was caused by the negligence of the insured and is therefore a separate incident. Clearly, this can have important ramifications for the impact of deductibles. Ultimately, however, the answers to such questions will depend on the circumstances of each case.

The material damage proviso

BI policies will normally require the insured to have in place at the time of the loss an insurance covering "the interest of the insured in the property at the premises" against loss and damage, and that payment must be made or liability admitted under that policy before a claim can be made under the BI cover.

The reason for imposing this proviso is so that the material damage policy will provide the insured with funds to make good any damage to its property. Otherwise, the recovery of the business might be held up by the insured's lack of funds. It also enables BI insurers to rely on the fact that the insured will have had to comply with any warranties or conditions precedent imposed by the material damage policy and that the material damage insurers will have carried out their own investigation into the circumstances of the loss.

The proviso, however, will be inoperative if the insured does not have sufficient interest in the property to insure it against material damage. In Glengate-KG Properties v Norwich Union Fire Ins Soc Ltd [1996], Glengate bought a property for redevelopment and took out a material damage and a separate consequential loss policy, which contained a material damage proviso. A fire destroyed the architects' work in progress drawings causing substantial delay to the project. Glengate had not insured the drawings, but claimed loss of rental income under the consequential loss policy. It was held that the drawings were owned by the architects and that Glengate had no interest within the meaning of the material damage proviso. "Interest" in this context must be a personal property interest, equating either with ownership or a proprietary interest recognised by law - ie narrower than the concept of insurable interest in insurance law. It follows from this that a material damage proviso will not apply to CBI cover, since the insured will not have a sufficient interest in the dependent property.

Of course, it is only when a disaster happens that many insureds discover the gaps in their insurance cover. Underinsurance, combined with inevitable cash flow problems, can cause insureds to become somewhat creative in the way they make their claims. For example, finding its contents to be underinsured, an insured may try to present the cost of replacing equipment as an extra expense under its BI cover, incurred to mitigate a loss of profit.

Finally, the calculation of losses to businesses following a catastrophe is a highly complex and time-consuming exercise. A high profile disaster, however, can add a further layer of complication if political and commercial pressure is brought to bear on carriers whose insureds have been affected by the devastation.

- Ling Ong is a partner in DLA Piper Rudnick Gray Cary's insurance and reinsurance group and Catherine Rawlin and James Stanbury are both partners of forensic accountants and consultants RGL.