May 20, 2022
Costly supply chain disruptions have hounded businesses worldwide since the pandemic began, and continue to do so today. Companies with complex global supply chains have encountered further disruptions in the wake of other recent catastrophes, including Russia’s invasion of Ukraine, which threatens critical supplies of products throughout the world. Businesses have historically protected themselves from supply chain disruptions through contingent business interruption (CBI) insurance, which covers their losses due to physical damage to the property of a supplier or customer. Below we examine the potential limitations of CBI coverage and the practical challenges of litigating CBI claims. We also discuss ways to draft stronger CBI policies and the growing popularity of other types of insurance in response to global supply chains that are increasingly reliant on just-in-time sourcing and that continue to be aggravated by recent disasters.
Who Qualifies as a Supplier or Customer?
An insured’s CBI recovery may depend wholly on whether the physically damaged third party is a “supplier” or “customer” under the policy. Insureds grapple with the risk that unknown entities may sustain physical damage, curtailing their operations, without triggering coverage. Insurers struggle to provide coverage without assuming liability for a limitless number of unidentified entities in the insured’s supply chain, often requiring that the insured have a “direct” relationship with the damaged entity.
Direct Suppliers. The most restrictive policies require that the third party is a “direct supplier” of the insured. In Millennium Inorganic Chemicals Ltd. v. National Union Fire Insurance Co. of Pittsburgh, PA, the Fourth Circuit interpreted the term “direct supplier” as requiring a legal relationship. 744 F.3d 279 (4th Cir. 2014). The insured, Millennium, purchased gas through a supplier, Alinta, who bought gas from a producer, Apache. When an explosion ceased Apache’s production, Millennium’s gas supply was curtailed, forcing it to shut down. Millennium argued that the producer, Apache, was its “direct supplier” because Apache provided the gas that went into Millennium’s pipeline. The Fourth Circuit disagreed, holding that the parties’ relationship was “interrupted” by an “intermediary”—Millennium’s supplier, Alinta—and, therefore, “indirect.” Accordingly, the court found that Millennium could not receive coverage for its CBI losses under the policy.
In Pentair v. American Guarantee & Liability Insurance Co., the Eighth Circuit also narrowly interpreted the term “supplier” even though the policy did not stipulate a “direct” relationship—the peril only had to damage the “property of a supplier of goods and/or services to the Insured.” 400 F.3d 613 (8th Cir. 2005). When an earthquake disabled a substation that powered two factories that manufactured products for Pentair, the factories experienced delays. The court determined that the substation was not Pentair’s “supplier” because, although it serviced the factories, it did not supply a product or service to Pentair. As such, the court found that Pentair’s CBI losses were not covered by the policy.
Indirect Suppliers. Conversely, in Archer-Daniels-Midland Co. v. Phoenix Assurance Co. of New York, a CBI policy included indirect suppliers where it covered losses incurred due to damage to “any supplier of goods or services.” 936 F. Supp. 534 (S.D. Ill. 1996). The insured sued to recover its increased transportation costs after flooding of the Mississippi River halted barge traffic. Relying on the phrase “any supplier,” the court concluded that the U.S. Coast Guard was a supplier of services to the insured since it maintained the Mississippi River system. However, policies seldom feature such expansive language.
Customers. CBI insurance also covers losses sustained due to physical damage to the insured’s customers. In CII Carbon v. National Union Fire Insurance Co. of La., the insured sold heat that escaped from its coke processing kilns to a neighboring plant. 918 So. 2d 1060 (La. Ct. App. 2005). An explosion rendered the adjacent facility inoperative and unable to buy the insured’s steam. The court found that the impaired plant was a covered “recipient property” and that the insured could recover for sales it lost during the plant’s restoration.
Policyholders may have greater flexibility in proving losses sustained due to damage to customers. For example, in Citadel Broadcasting v. Axis U.S. Insurance Co., the insured radio station owner sought coverage for its lost profits in the wake of Hurricane Katrina. 162 So. 3d 470 (La. App. Ct. 2015). It presented evidence that its customers’ businesses were destroyed, but the insurer insisted that Citadel prove individual losses for each customer. The court disagreed, reasoning that the policy did not measure losses using “customer-by-customer proof”; Citadel’s losses should be calculated by comparing its “expected performance prior to Hurricane Katrina with its actual performance thereafter.”
Territorial Restrictions in CBI Policies
Since CBI coverage involves physical damage to a third party’s property, questions also arise regarding whether the third party must be within the policy’s territorial restrictions. In Park Electrochemical v. Continental Casualty, an explosion in Singapore prevented an American insured from receiving a manufacturing component. 2011 U.S. Dist. LEXIS 16344 (E.D.N.Y. Feb. 18, 2011). Because the policy limited coverage to the United States and Canada, the insurer argued that the physical damage occurred outside the policy’s geographical scope. Unpersuaded, the court found that the insured loss was not property damage but the financial shortfall sustained by the American insured.
Practical Challenges of Litigating CBI Claims
CBI claims present unique litigation challenges because they involve physical damage to a third party whom neither the insured nor the insurer controls. Reliance on an external partner can hamper fact-finding for both parties who may lack access to the property and relevant records. The parties may be in the dark as to the scope of the damage or timeframe for repairs. Where multiple perils contributed to the loss, the parties may struggle to show which peril was the predominant cause—an outcome determinative analysis in many courts.
CBI insurance generally limits recovery to the time it would reasonably take to restore the damaged property. However, an insured may have difficulty establishing a timeline or ensuring timely repairs of another’s property. In order to maximize coverage, insureds should confirm that their supply chain partners have protocols in place to make any necessary repairs within a reasonable timeframe.
Additional issues arise regarding the period of restoration because supply chain issues may not manifest until long after the damage occurs. This makes it critical for businesses with long production pipelines to negotiate an expansive period of indemnity. Pennbarr v. Insurance Co. of North America serves as a cautionary tale. 976 F.2d 145 (3d Cir. 1992). In Pennbarr, an American retailer sold typewriters that were manufactured by its Italian subsidiary. Earthquakes halted the subsidiary’s operations and, during the restoration of its facility, Pennbarr used its existing inventory to fulfill demand. Upon depleting its stock, Pennbarr was unable to fulfill sales despite the subsidiary becoming operational because of the manufacturing lead-time. Pennbarr sought to recover the profits it would have made had it received additional typewriters, but the court found that the policy only covered losses incurred while the subsidiary was inoperative. Given its obligation to mitigate damages, Pennbarr was required to sell the inventory that it had on hand. Its only option would have been to negotiate a longer period of indemnity that better reflected its business needs.
Drafting Stronger CBI Policies
With COVID-19 having highlighted the importance—and limitations—of CBI insurance, insureds and insurers are increasingly focusing on supply chains during the underwriting process. Given the expansiveness of modern supply chains, insurers will want to limit coverage to losses caused by physical damage to their insureds’ “direct” suppliers and customers. Insurers seeking to limit coverage for losses resulting from physical damage within certain territorial limits, regardless of where the financial loss occurs, must clearly evidence their intent; they cannot rely on the policy’s general geographic scope. Insurers should closely assess coverage grants, weighing whether they should lower limits or exclude specific entities.
By contrast, insureds should advocate for broad definitions of “supplier” and “customer.” Because courts often interpret “supplier” narrowly, insureds should name entities that present bottlenecks in their supply chain. This is particularly important for businesses who rely on a key supplier. Businesses who deal with intermediaries or lack contractual privity with third parties should also negotiate for policies that extend to “indirect” entities. For companies that rely on neighboring businesses to attract customers, a “leader” or “attraction property” endorsement may cover losses sustained due to physical damage to an “anchor” store or within a given radius of the insured. Finally, insureds dealing with complex supply chains may want their coverage to include unnamed suppliers or customers. While insurers may hesitate to offer such expansive coverage, the parties could leverage a tiered system where unnamed third parties have lower recovery limits. This enables insurers to control their risk and diligent insureds to reduce their premiums without eliminating coverage.
Looking Beyond CBI: Supply Chain Insurance
Even with improved drafting, CBI insurance may not be enough since it traditionally requires that a supplier or customer sustain physical damage to goods or property. Many courts dealing with the influx of COVID-19 cases have interpreted this requirement narrowly, finding that the presence of a virus does not constitute physical loss. With CBI coverage under scrutiny, separate supply chain insurance is gaining traction as a solution for broader, supplementary coverage. This insurance may allow the policyholder to sidestep the physical damage requirement and tailor coverage to its business needs. Supply chain coverage can offer wary insureds protection against losses stemming from disruptions experienced by third parties due to various unforeseen circumstances such as viruses, war, labor shortages, power outages, and other events.
Reprinted with permission from the May 20, 2022 edition of the NEW YORK LAW JOURNAL © 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 - firstname.lastname@example.org