The hurricane Sandy business interruption conundrum

The issue of business interruption and contingent business interruption insurance losses is becoming a major conundrum when it comes to estimating the total insured loss caused by hurricane and post-tropical storm Sandy. Business interruption claims can take weeks to develop, longer to be reported and quantifying the actual exposure is tricky. Add to that uncertainty around whether insurance policies include business interruption and the insurance and reinsurance industry has a job on its hands.

Reports that came out yesterday and today from various market observers suggest that business interruption will be a real issue from Sandy. The problem with business interruption is that there are so many unknowns that the claims total from BI can very quickly escalate. How business interruption is written into insurance policies is a factor, as some may exclude BI resulting from a government induced shutdown of New York, some insurers policies may exclude BI unless it is contingent on actual damages from an event. Flood applicability to BI claims is also a potential contractual issue in insurance policies. Contract technicalities can make a big difference to BI claims, so expect there to be disputes and much uncertainty over the level of business interruption losses from Sandy.

Dan Gerber, from law firm Goldberg Segalla, commented; “Sandy will likely cause significant business-interruption losses. The key issue will be determining applicable coverage for these claims and appropriate restoration periods. Two key issues insurers will be looking at are causation and calculation of damages. They will examine whether the damage resulted from flood, often an excluded loss, or wind and wind-driven-rain. Additional coverage may be implicated if a sewer backup of some sort occurred during flooding.”

“In the aftermath of Sandy, a number of complicated issues will arise when insurance companies assess the level of pay-out they are facing on business interruption claims. These include: is the lost income claimed based on historical figures or figures in the post-damage community; and did the market circumstances change after the disaster that would have rendered the business more valuable and profitable if it had been open?”

“When assessing loss of profits for a business, it is vitally important that accurate calculations are made, so a forensic accountant should be engaged at an early stage to work through the problem and analyze the expenses as they are being incurred.”

“Business interruption insurance requires a suspension or interruption to the insured’s business to trigger coverage, and most courts have ruled that the cessation of business must be total, not merely a slowdown or decrease in expected profit, unless the policy specifically provides otherwise.”

“Ultimately, businesses want their claims adjusted timely and accurately, and insurers will want complete information from insureds. To achieve this, it is important that appropriate financial models are in place, that claimed losses are carefully documented, and that claims are carefully investigated to ensure they are covered by the policies in place.”

Fitch Ratings said in a release late yesterday that business interruption from Sandy could cause big losses for the insurance industry. Fitch expects that flooding from excessive rainfall and high storm surge will be a substantial component of damages from Sandy, in addition to damage from the storms strong winds. They stress that it is important to note that homeowners’ policies cover wind losses, but generally do not cover flood losses. Conversely, many commercial policies cover both wind and flood losses, as do crop insurance policies. This complication can add to the delay in calculating an overall industry loss for the event.

Fitch said that there is the potential for significant business interruption (BI) and contingent business interruption (CBI) losses related to the flooding as the affected areas work to restore power and resume operations following the storm. Sandy has impacted a wide variety of businesses in densely populated areas, including retail, corporate offices, transportation, manufacturing, and energy plants, many of which will have BI policies or clauses in their policies and now good reason to claim on them.

Fitch ratings explain:

Extensive BI and CBI losses were experienced by the insurance industry last year in both the Japanese earthquake and tsunami and Thailand floods, as they accounted for a considerable portion of commercial and industrial losses. Fitch also notes that these events demonstrated the extent to which BI and CBI losses have been underestimated in the modeling and underwriting of risks.

In order to incur a BI or CBI loss, an insured must suffer an actual loss of income from the suspension of operations. In the case of BI, the interruption must be due to physical loss or damage to its own property as a result of a covered cause of loss. A BI claim can also be triggered if the work location is not accessible due to a “civil authority” order telling people to stay out of an area. CBI provides an additional protection that covers loss of income when the insured’s operations are disrupted by a supplier and covers the same perils as the main policy of the insured. However, the majority of companies do not purchase CBI policies.

Coverage typically begins following a waiting period, most often 72 hours, and continues for the length of time it takes to repair, rebuild, or replace the damaged or destroyed property with reasonable speed and similar quality. Thus, the ultimate insured losses from BI and CBI will be partly predicated on the speed with which businesses resume operations. It is also important to note that the vast majority of BI and CBI coverage purchased in the U.S. is included as part of the insured’s property policy, and are thus included within the overall property policy’s coverage limits.

Alex Denslow, a partner at law firm CMS Cameron McKenna agrees and is quoted in the Post Magazine here saying that insurers may struggle to define causes of damage, which could confuse BI claims. “Damage has been caused as a consequence of wind, water, snow, fire, inland flooding and storm surge. Insurers will need to check policy coverage carefully to determine the scope of cover,” he said. “As in the case of the New Zealand earthquakes, there may be practical difficulties for adjusters in determining the cause of loss due to inability to access areas that may be affected.”

Also in their regular legal update emails CMS Cameron McKenna said; “Insurers will need to consider whether their policies cover business interruption as a consequence of government action or as a preventative measure, or whether business interruption is contingent on material damage.” They mention the tourism industry as a prime example of one hit by Sandy and facing business interruption issues.

Reinsurance payouts could increase due to these business interruption claims as some will likely trickle through to be dealt with by reinsurers, although again contract wording will matter and disputes are possible. For catastrophe bonds, generally business interruption and contingent business interruption are included as part of an ultimate net loss or industry loss total so many have some exposure to this. It does raise into question how qualifying losses are calculated for cat bonds given the length of time it can take for interruption claims to fully develop. Hence the calculation methodology documentation is so important in cat bond, and ILW, transactions as it defines how long the gap between event and calculation report can be.

So, business interruption is likely to prove a conundrum for insurers, reinsurers and anyone assessing the extent of the insured loss from Sandy. Loss development could go on for some time, similar to that seen in Thailand and New Zealand where loss estimates rose months after the events. It’s important that the industry continues to look at ways to better understand business interruption and tries to develop new tools to hedge this risk explicitly as that would help to avoid any confusion caused by policy wording.