When Hurricane Sandy struck New Jersey last week, one of my out-of-state lawyer friends, employing the sort of dark humor that perhaps only other lawyers can appreciate, congratulated me on my “happy positioning in the world’s greatest business interruption insurance goldmine.”  I told him that, unfortunately, this time I might be a plaintiff instead of coverage counsel.  Luckily, through yeoman’s work by my firm’s staff, we were able to get up and running again fairly quickly (although without heat for awhile). 

I know that, in the wake of this terrible disaster (described by some as “Katrina without the body count”), virtually every insurance broker and coverage lawyer is rushing to publish articles and blog posts on property coverage.  Given my friend’s comment, and not to be outdone, I thought I would take a brief look at a couple of important aspects of the law relating to business interruption insurance, based upon a Third Circuit case from a few years back.

The case is Eastern Associated Coal Corp. v. Aetna, 632 F.2d 1068 (3d Cir. 1980), and while it involved a fire rather than a hurricane, it neatly illustrates some of the typical problems encountered with business interruption claims.

Basically, Eastern owned a coal mine that suffered an underground fire.  With respect to the business interruption aspect of the claim, Eastern wanted reimbursement in two areas.  First, Eastern wanted compensation for the sales value of a portion of the coal that would have been mined by Eastern during the interruption covered by the policy.  Second, Eastern wanted reimbursement for expenses incurred by Eastern in obtaining alternative coal to fulfill its contractual obligation to supply metallurgical coal from the mine to Sharon Steel Corporation.

Let’s begin with the good news for Eastern.  There’s no question that there was a covered loss – fire was a peril covered by the policy – and that the potential for business interruption coverage therefore existed.  Without physical damage caused by a covered peril, there can be no business interruption coverage.  This showcases the need to follow the first rule of coverage work:  Read The Policy.  You can bet there will be a lot of battles in the Sandy arena over whether a covered peril exists.  First party policies, for example, may exclude flood damage but include wind damage. 

Now, let’s briefly define the type of coverage provided by business interruption insurance.  BI insurance is meant to cover “but for” income – that is to say, income that the policyholder would have realized “but for” the physical damage.  Business interruption loss, then, is the difference between (A) what the policyholder would have earned, and (B) what the policyholder actually earned, during the loss period.  If net income equals revenue less expenses, then lost income for BI purposes equals (1) “but for” revenue minus “but for” expenses, LESS (2) actual revenue minus actual expenses.

This formula may seem simple, but it’s precisely where many disputes arise between policyholders and insurance companies.   Insurance companies are forever contending, for example, that the “but for” side of the equation is too speculative – which is exactly what happened in the Eastern case.

Under the coal supply contract, Eastern agreed to furnish Sharon’s metallurgical coal requirements, estimated at 250,000 tons annually, for a ten-year period. The contract contained base prices for coal, and an escalator clause to cover increases in the cost of production. The contract contained a provision that required all metallurgical coal to have a sulphur content of less than 1.6%. 

The insurance companies argued that all of the metallurgical coal would have been sold to Sharon under the contract. If so, the total recovery under the policies for lost production would have been $5.3 million.  Eastern, however, argued that 77,000 of 181,000 tons of lost metallurgical coal production would have been rejected by Sharon because they would have had a sulphur content in excess of the 1.6% requirement under the contract. If so, the 77,000 tons would have been sold on the open market and would have been valued at a higher market price, increasing the recovery from the carrier by almost $900,000.

To prove its point, Eastern submitted evidence of the sulphur content of the coal remaining in the metallurgical portion of the mine at the time of the fire. This data had been obtained by analyzing bore samples of coal from the metallurgical section of the mine. Eastern argued that this data showed that approximately 77,000 tons of metallurgical coal in the mine had a sulphur content ranging from 1.6% to 2.0%.  The jury bought this argument.  Unfortunately for Eastern, though, there was testimony at trial that the coal routinely underwent a “washing” process before sale, which would reduce the sulphur content by an unspecified amount.  The appeals court overturned the jury verdict, writing:  “Without evidence of the effectiveness of the washing process, the jury could only speculate concerning the sulphur content at the time of delivery. There is no evidence from which the jury could infer the effectiveness of washing.”

It’s easy for me to play Monday morning quarterback 30 years later, but how difficult would it really have been to provide an analysis of the effectiveness of the washing process?  Probably not very.  That leads me to two possible conclusions.  First, the data was not good for the policyholder, in which case the policyholder was simply hoping for a $900K windfall.  Second, someone got lazy.  Never get lazy on a business interruption claim, especially a sizable one.  The carrier is going to look for any way it can find to knock down the policyholder’s number or argue it’s too speculative.  It’s important to think through all aspects of the claim and provide conservative, justifiable data.  Always be thinking about how things will play out in Court (and try to avoid getting there).

The second element of the claim involved additional expense incurred by Eastern to comply with its supply contract with Sharon.  On this element, the Court interpreted the policy quite strictly, writing:   “Eastern argues that its substitute and brokerage coal expense was ‘incurred by the Assured to reduce loss’ caused by the interruption and, therefore, is covered by the policy. We do not doubt that Eastern’s liability to Sharon was reduced by its resort to substitute and brokerage coal. However, Eastern fails to take account of the exact words of the policy. The provision compensates insureds for expenses incurred ‘to reduce loss hereunder’. We believe the phrase ‘loss hereunder’ plainly refers to loss compensated under the policy.”  In other words, the additional expenses were not aimed at reducing loss under the policy, but at reducing contractual liability to a third party.

From the perspective of Sandy, the reason I mention this second ruling is that you can’t simply assume that all additional expense will be covered under a business interruption form.  In fact, until you have a commitment in writing from the carrier, it’s safest to proceed from the assumption that none of the additional expense will be covered, unless and until a court decides otherwise.  As a wise man once said, bank in the bank, not in your head.

If you’re interested in reading the entire Eastern Associated decision, click here