The Tohoku earthquake on 11 March was a magnitude 9.0 undersea earthquake that triggered powerful tsunami waves that travelled in shore, causing extensive damage. Media coverage was substantial, reporting the effect of the shutdown of the nuclear plants but also some conventional electricity supply plants by the Tokyo Electric Power Company. There was also disruption to railways, with trains being cancelled or run less frequently. It appears the full magnitude of that disaster has not yet reached international shores, with much of the direct insurance exposure apparently contained in the Japanese market. However, the market is conscious of foreign reliance upon Japanese production, particularly in electronics and the automotive industry and is fearful of exposure to Contingent Business Interruption (CBI) claims.

In March we heard press reports of reductions in car and steel manufacture.

An article in the Economist online dated 19th May stated that the quake “ravaged the suppliers of critical parts and raw materials in north-eastern Japan”. They commented further that: “it only takes one missing part to bring an assembly line stuttering to a halt”.

So, what issues are likely to arise when considering CBI cover? Some guidance can be found in a consideration of an incident that occurred just over three years ago that had wide spread CBI consequences.

On 3 June 2008, a gas explosion occurred at a facility on Varanus Island, off the North West Coast of Western Australia. As a result, Western Australia’s gas supply was reduced by approximately one third. Subsequently, a large number of claims based on contingent business interruption were notified to the London market.

Significant commercial enterprises were interrupted or unable to function, because of the lack of gas coming from the facility. Whilst some gas was available by August 2008, this was insufficient to satisfy the requirements of all those who had contracted with suppliers. The large number of claims demonstrated that the accumulation risk to insurers’ in respect of CBI cover should not be underestimated.

How does the cover appear in the policy?

In common with other “Anglo centric” CBI policies, in the standard ISR wording used in the Australian market place, CBI cover is provided by “Customer and Suppliers” and “Utilities” extensions. The terms of the customers and suppliers extension in particular could be wide or narrow, i.e. providing cover in respect of property owned, utilised or operated by any direct or indirect suppliers, customers etc.

Subject to the operation of the other terms and conditions of the policy, these extensions provide cover for the insured in respect of their business interruption losses, resulting from material damage to the property of third parties. In order for a CBI claim to be indemnifiable, the requirement for physical damage to have occurred still exists. However the damage to the relevant property must also have resulted in an interruption to or interference with the business of the Insured. Underwriters may have little or no knowledge of the third party property and the risks to it when agreeing to provide CBI cover, often subject to high sub-limits.

This is an important risk management point. It is essential for underwriters to consider all of the potential CBI losses that could affect their Insured’s business, when assessing whether or not to underwrite a risk and on what terms/at what rate. For example, does the insured have alternative sources of supply in the event that a major supply is interrupted? This situation came to the fore after the Varanus Island incident, when it became clear that it was extremely difficult to maintain supply to a vast and diverse array of businesses and residential customers.

Named vs unnamed: direct vs indirect

CBI extensions often contain important terms which, perhaps because CBI extensions are often a “bolt on” to property policies, are undefined. It is important in assessing insurers’ exposure to consider applicable sub-limits e.g. for “named” or “direct” suppliers as opposed to “unnamed” or “indirect” because insureds usually have higher sub-limits for Named counterparties. Problems arise when they are not accurately described (for example referring to a particular company when it is actually a subsidiary or associated company which is in contract with an insured). Problems also arise in defining what proximity of relationship is required for a “direct” supplier when that is not defined. Is it a key supplier? One which is in direct contract with the insured? Or via a direct chain of contracts albeit via intervening parties?

Policy terms that do not fit

One of the problems with CBI cover arises from the fact that the underlying policy terms are designed to deal with the consequences of damage to the insured’s property and may not be as well suited to damage to a third party’s property. For example, the policy may impose an obligation on the insured to mitigate its loss. How can the insured do so when they have no control over and potentially no knowledge of the process and timeline of third party repairs?

The policy may also contain a “Precautions to Prevent Loss” clause, under which the insured must use reasonable precautions to prevent loss, destruction or damage to the property insured by the policy. Arguably this clause is rendered useless in the context of a CBI loss.

Concerns for the Aajuster

A CBI loss may pose interesting legal questions in relation to the wording of the policy, but often it presents a significant challenge to the adjuster as well. Following the incident on Varanus Island, those adjusting CBI claims had no access to the site of the property damage. This made it difficult for them to comment on the time-line of repair or to assess the appropriateness of decisions taken by the insured (themselves ignorant of repair timelines) on additional expense intended to avert BI losses.

Even if information is available, adjusters may also find themselves constrained by the fact that information relevant to the adjustment may be commercially sensitive (i.e. contract prices) and the insured may be prevented or limited in what they can pass on due to confidentiality obligations.

Contract pricing raises another relevant consideration in the adjustment of a CBI loss. We are all aware of the importance of “causation”. With the potential for commercial disputes over the price of products supplied to the insured and actions they may take that could affect and indeed increase the loss they suffer, adjusters must consider if the chain of causation has been broken, so as to minimise the insurable loss under the policy. We must always return to the question, was the insured’s loss caused by the relevant damage, rather than some extraneous cause such as a contractual dispute between supplier and insured, or insured and customer.

CBI potential in the wake of Japan

If a CBI loss arising from the incident is reported to insurers, obviously the potential operation of exclusions such as those relating to earthquake, tsunami, or nuclear risks will have to be considered. However, in addition, the terms of the relevant extensions and the chain of causation must also be reviewed. Insurers should look at what has actually caused the supplier (be it direct or otherwise) to cease or reduce supply to the insured.

There is also a serious issue to be considered (as it must be in any Property/BI loss involving widespread devastation) regarding the correct application of the “other circumstances” clause when looking at adjustments to “Standard Turnover” while assessing BI losses. What must be assumed not to have occurred? The peril? Or the damage to the third party’s property relevant to the operation of the CBI extension? The law on that issue is uncertain in many of the world’s premier “insurance law” jurisdictions.