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March 15, 2013

As memories of Hurricane Sandy drift into the past and the next extreme weather event arises, many well-performing companies that suffer damage from these perils may be in for a big surprise when seeking recovery of their business interruption losses. It may seem ironic, but firms with some of the strongest financial results — those that could not even keep up with their orders prior to the loss — may be the most surprised when attempting to settle their claims.

Companies purchase business interruption coverage to protect their business income stream against losses attributable to an insured peril such as a windstorm, fire, flood or explosion. If an insured’s business is doing particularly well  so much so that it cannot keep up with demand, for example  could it be penalized with a denial of coverage in the event of what it deems to be a substantial loss? What was the intent of the parties when they entered into the insurance contract? Why might the claim be much smaller than anticipated? What basis might an insured have to seek recovery? In this issue of Raising the Bar, A&M addresses these and other issues that could arise in connection with business interruption claims of insureds with order backlogs.

A Hypothetical Case Study
Consider a hypothetical heavy equipment manufacturing company, FarmCo, that suffered Hurricane Sandy-related property damage at one of its locations. Assume the damaged location produced attachments such as plows and buckets to connect to farming equipment (carrier units). Also assume that the physical damage to the plant took six months to repair and that production of the attachments ceased during that time. Lastly, assume that no alternate facilities or substitutes existed for FarmCo’s attachments through other manufacturers and that FarmCo had a significant attachment order backlog of two months’ worth of production when Sandy hit.

FarmCo sold some of its attachments to customers who had already purchased carrier units either as replacements or to use the carrier units for a different purpose (e.g., plowing fields versus moving dirt). However, it sold most of its attachments with contemporaneous sales of carrier units to customers that sought both the machine and attachment with a specific purpose in mind.

Policy Considerations
FarmCo’s property insurance policy covered lost business income  defined as lost gross earnings less non-continuing expenses. The company’s policy language indicated that lost gross earnings could only be recovered if FarmCo was “able to demonstrate a loss of sales for the operations, services or production prevented.” FarmCo also purchased extended period of indemnity (POI) coverage to cover lost gross earnings from the time repairs were completed through the time the business returns to the condition that would have existed had no loss occurred (up to one year past the repair date). Lastly, its policy provided coverage for interdependent losses at its different locations.

FarmCo’s policy also contained exclusions applicable to the lost gross earnings and extended POI coverage. First, coverage under the policy’s extended POI provision specified that “the reduction in sales due to contract cancellation will include only those sales that would have been earned under the contract during the extended period of indemnity.” Second, coverage is barred for any increase in loss due to “suspension, cancellation or lapse of lease contract, license or orders” or “any other consequential or remote loss.”

The Claim
FarmCo sought recovery of lost business income associated with lost sales of attachments during the six months that the attachments production facility was being repaired (Category 1 losses). It also sought recovery for lost business income associated with lost sales of attachments and carrier units that would otherwise have been produced and sold within the extended POI (Category 2 losses). Such losses constituted lost orders that were never placed with FarmCo because of the unavailability of attachments. For example, suppose a farmer needed a plow and tractor for his spring harvest. If the plow was not available for eight months (original backlog of two months plus six-month plant closure), then the farmer would not buy the tractor or the plow from FarmCo and instead go to a competitor in light of his immediate need.

Quantum and Coverage Considerations
The quantum picture is relatively clear for the Category 1 losses described above. Analysis of industry data, as well as FarmCo’s P&Ls and production at the damaged location, demonstrated lost sales of attachments during the six-month indemnity period. However, the calculations supporting the Category 2 losses were less clear. Since there was a significant backlog of attachment orders at the time of the loss, there was no apparent decline in sales or production after repairs were complete. The backlog for attachments, however, increased from two months to eight months and this caused orders to decline for both attachments and carrier units, as customers with existing needs could not wait that long for order fulfillment. Analysis of industry and company data clearly demonstrated a significant amount of lost orders. Such orders would have been produced and sold during the extended POI.

The policy exclusion related to the reduction in sales due to contract cancellation does not appear to apply because such income would have been earned under the contract during the extended period of indemnity. In addition, the majority of lost sales suffered were due to orders never placed, rather than cancelled orders. The exclusion related to any increase in loss due to “suspension, cancellation or lapse of lease contract, license or orders” also appears irrelevant for the same reasons. The consequential loss exclusion may have some applicability, but the interdependency provision and other policy language appears to provide strong support for coverage. For example, if FarmCo was able to burn off its backlog before the end of extended POI (365 days), would a loss suddenly materialize because the decline in orders would then translate into lower sales and production? Such an argument seems to defy logic.

There are both controllable and uncontrollable factors that could impact the loss. Controllable factors might include increasing the supply (and accelerating the backlog reduction) through expansion of capacity on new or existing plants, cessation of taking new orders or extension of shifts to run 24 / 7. They also might include reducing demand by increasing prices. Non-controllable factors could include decreased demand from a recession or enhanced competition. Regardless of whether a controllable or uncontrollable factor factor impacted the loss, burning off the order backlog more quickly does not seem like it should determine whether a Category 2 loss was sustained by FarmCo. Obvious lost orders that are well-supported and would have been produced and sold during the extended POI, if the attachments plant had not been damaged, provide a strong basis for recovery.

Businesses with strong demand or weak supply (or both) that have attendant order backlogs may find themselves with coverage denials because sales and production declines associated with loss orders may not be easily identifiable until the backlog is eliminated. Experienced coverage attorneys and loss adjustment professionals can help policyholders identify comprehensive losses to achieve appropriate settlements.