The economic impacts of the earthquake and tsunami that ravaged northeast Japan on March 11, 2011 are beginning to ripple across the globe. Numerous industries have been affected by the disaster, as Japan’s productive capacity has been seriously compromised. Japan’s semiconductor industry—which represents about one-fifth of the global market1—is facing significant disruption to its manufacturing capabilities. Toyota, the world’s top-selling carmaker in 2010, is expected to cede this position to General Motors this year because of disruptions to its parts supply chain.2 Most recently, electronics giant Sony, which had nine plants damaged in the disaster, forecast a $3.2 billion loss for its recently-ended fiscal year.3 These are but a few of the large Japanese manufacturers to suffer significant impacts from the March 11 disaster.  

The disruption of industry in Japan is, in turn, disrupting industry around the world. With numerous multinational corporations relying on Japanese suppliers for parts for their products, losses are being incurred all the way up the supply chain. Many smartphone manufacturers, automobile manufacturers, and other high-tech firms expect to incur losses as a result of shortages of parts from Japanese suppliers.

Contingent Business Interruption Insurance May Be Available

Contingent business interruption (“CBI”) coverage is not included in standard business interruption (“BI”) coverage, but may be purchased as an extension. Unlike BI insurance— which protects against the loss of prospective earnings because of an interruption to the policyholder’s business caused by covered damage or loss to the policyholder’s own property—CBI insurance provides coverage when a supplier or key customer suffers a direct physical loss, which, in turn, disrupts the business operations of the policyholder.4 In other words, CBI coverage is triggered when the policyholder can’t operate because its supplier can’t operate, even if the policyholder has suffered no direct physical damage.

The purpose of CBI coverage, therefore, is to protect policyholders who experience a loss as a result of damage to property of a supplier or customer on whom the policyholder’s business is dependent.  

Typically, CBI provides coverage for loss of income and extra expenses incurred because of, for example, a reduction in earnings caused by an interruption in the supply of necessary components or the additional cost of obtaining goods from alternative sources. However, it is important to keep in mind that CBI coverage is subject to several limitations. First, there is usually a time element or deductible limitation. That is, coverage for lost income will apply only after a waiting period or after a deductible is exceeded. For instance, the policy may provide that loss of income will only be covered for the period beginning 72 hours after the time of the direct physical loss, or in excess of a stated dollar amount. Coverage also may be limited to the period of restoration—that is, the losses incurred during the period reasonably required to repair, rebuild, or restore the supplier’s normal operation. In addition, coverage is usually restricted to a particular coverage territory. A loss may not be covered if it occurred outside the coverage territory of the policy.  

Also relevant to the CBI coverage issues that may arise out of the March 2011 earthquake and tsunami in Japan are two common policy exclusions. Many insurance policies exclude coverage for disruption of business due to a nuclear reaction or radiation contamination. Moreover, as discussed in further detail below, CBI coverage typically is not available where the supplier has suffered only an interruption in power supply. See Pentair, Inc. v. Am. Guar. and Liab. Ins. Co., 400 F.3d 613 (8th Cir. 2005). In addition, most policies exclude coverage for losses from earth movement and flooding, as well as other types of water damage, although some resulting losses may still be covered, such as fire ensuing from an earthquake. Specialty flood insurance and other policies may fill these gaps.

Issues to Consider in Preparing a Claim

Before filing a claim under your policy’s CBI provision, it is important to bear in mind that preparing a CBI claim is often more complex than preparing a BI claim, largely because the policyholder must assemble documentation to show damage to a third party’s property, as opposed to its own. Moreover, because of the complex business models in use by many of the world’s sophisticated companies, contingent business interruption losses may occur at a variety of locations. It is therefore important to understand fully the links in your supply chain in order to know when CBI coverage is triggered. Likewise, it is important to understand what constitutes a covered peril under the CBI provision. Finally, an understanding of how property loss is measured is critical in preparing a claim. Several cases addressing these issues are instructive.

In Pentair, an earthquake disabled a substation that provided electric power to two Taiwanese factories. As a consequence, the factories were unable to manufacture products they supplied to subsidiaries of the policyholder, Pentair. The Eighth Circuit rejected Pentair’s argument that the Taiwanese substation was a Pentair supplier within the meaning of the CBI provision in its policy, reasoning that “though the substation supplied power to the Taiwanese factories, the Taiwanese power company did not supply a product or service ultimately used by Pentair.” 400 F.3d at 615. The Eighth Circuit likewise rejected Pentair’s argument that its Taiwanese suppliers’ inability to function constituted “direct physical loss or damage,” thus triggering CBI coverage. The court held that “mere loss of use or function” does not constitute property damage for purposes of CBI coverage. Id. at 616-18.

Pentair has significant implications for policyholders with suppliers in Japan, particularly in light of the rolling blackouts and power shortages caused by the loss of power at the tsunami-damaged nuclear reactors at the Fukushima nuclear power plant. Perhaps most importantly, under Pentair, a loss of power by itself does not constitute “physical loss or damage” under a contingent business interruption endorsement. This means that a supplier must have sustained some physical loss or damage, not a mere loss of electrical power, in order to trigger CBI coverage. Therefore, where Japanese suppliers are unable to manufacture goods because of rolling blackouts or other power outage issues, CBI coverage may not be available unless the supplier has also sustained direct physical damage or loss.

Another court similarly has held that economic loss does not constitute direct physical loss or damage. In Philadelphia Parking Authority v. Federal Insurance Co., 385 F. Supp. 2d 280 (S.D.N.Y. 2005), the policyholder operated a garage attached to the Philadelphia International Airport. Following the September 11 terrorist attacks, an order was issued grounding all civil aircraft, thus effectively shutting down the airport. The court rejected the policyholder’s claim that it was entitled to coverage under the CBI provision in its policy, which required that the interruption of operations take place “as a result of direct physical loss or damage” and not “based on purely economic damage.” Id. at 287. Philadelphia Parking Authority thus underscores the requirement that the contingent business premises must have suffered a direct physical loss or damage.  

Pentair also suggests that the damaged Fukushima reactor is unlikely to be considered a supplier for purposes of CBI coverage, unless it is a direct supplier to the policyholder or it is specifically included in the policy’s CBI endorsement. See Pentair, 400 F.3d at 618.

(“Extending [CBI] coverage to [ ] losses resulting from power outages at unknown third party supplier premises, which may be located all over the world, insures a different and presumably more substantial risk.”) That is, even though a policyholder’s supplier may depend on the Fukushima plant for its power supply, this alone is unlikely to be sufficient to trigger coverage. But another case suggests that whether a vendor is considered a supplier for purposes of CBI coverage depends in large part on the policy language.

In Archer-Daniels-Midland Co. v. Phoenix Assurance Co., 936 F.Supp. 534 (S.D. Ill. 1996), the CBI endorsement covered damage to property of “any supplier of goods or services which results in the inability of such supplier to supply an insured locations [sic].” 936 F.Supp. at 540 (emphasis added). The policyholder, a processor of farm products for domestic and international consumption, was unable to transport its goods via the Mississippi River system due to unprecedented flooding. Focusing on the “any supplier” language in the CBI endorsement, the court concluded that the United States Army Corps of Engineers and the United States Coast Guard, which operate and maintain the Mississippi River system, were “suppliers of goods and services” under the policies, despite the lack of a contractual relationship. 936 F.Supp. at 541. Archer-Daniels-Midland therefore suggests that the supplier-manufacturer relationship may be indirect.  

Pentair and Archer-Daniels-Midland indicate the importance of carefully examining the language of your policy’s CBI endorsement in order to determine whether a particular entity qualifies as a supplier under the terms of the policy. In addition, because CBI coverage may extend to indirect suppliers in some circumstances, it is essential to fully understand the links in your supply chain.

Finally, policyholders should be prepared to prove the amount of income that would have been earned but for the business interruption. This is often a complex calculation and involves persuading the insurer to accept the accounting methodology used by the policyholder—a process that almost always requires the retention of a forensic accounting expert. The case of Wyndham International, Inc. v. Ace American Insurance Co., 186 S.W.3d 682 (Tex. App. 2006), illustrates the importance of a careful and precise expert opinion. In Wyndham International, a hotel chain filed a claim under the CBI provision in its policy for business lost following the travel restrictions imposed after the September 11 terrorist attacks. After some discovery and several motions for summary judgment, the insurer moved to exclude the opinion of Wyndham’s sole damages expert. The court granted the insurer’s motion, concluding that the expert testimony was unreliable. First, the court emphasized that the expert relied on business forecasts that were not prepared according to any companywide “hard and fast rules.” Id. at 687. In addition, the accounting expert extrapolated revenue projections for 62 Wyndham properties based on forecasts for 101 of its properties, and any unreliability of those forecasts “taints [the expert’s] extrapolated projections.” Id. at 687-88. Lastly, the court found that the expert’s failure to compensate for other possible causes of lost income, besides the travel restrictions imposed after September 11, “render[ed] his opinion little more than speculation. An expert who is trying to find a cause of something should carefully consider alternative causes.” Id. at 689.

Wyndham illustrates the loss valuation issues that may arise even where an accounting expert is retained. Policyholders should be prepared to provide accurate and complete accounts of their losses and support the claim with documentation. Placing an emphasis on these processes early is often overlooked when faced with a crisis of the magnitude of the Japan earthquake and tsunami. Nevertheless, doing so will optimize the chances of minimizing the losses incurred and allow policyholders to focus on the issues that matter most— rebuilding and recovering.