Does Your Insurance Cover Supply Chain Disruptions?

The recent West Coast port slowdown and East Coast weather events highlight the vulnerability of the global supply chain. Short product life cycles, erratic consumer demand, an abundance of product variety, and complex global supply chains make the fashion and apparel industry even more vulnerable to supply chain issues.

Fashion designers, manufacturers and retailers are all too familiar with cancelled orders, lost sales and extra expenses associated with supply chain disruptions. But what many don't know is that insurance can be a valuable tool in offsetting many of the losses associated with such disruptions.

For example, commercial property policies often include coverage for business interruption, extra expense, contingent business interruption and contingent extra expense. Business interruption insurance typically covers lost profits caused by damage to a policyholder's own property. Likewise, extra expense insurance typically covers the additional expense a policyholder incurs to keep its business running because of damage to its own property.

Contingent business interruption (CBI) and contingent extra expense (CEE) insurance also cover lost profits and extra expenses, respectively. However, they do not require any property damage to the policyholders' own property. Rather, they provide coverage for losses arising out of policyholders' dependence on others (such as suppliers and customers) for their continued operations. Requirements to trigger CBI and CEE coverage vary, with most policies still requiring that the third party at least suffer property damage, as discussed below.

For example, assume that a Los Angeles based apparel company sources its fabric from a supplier in Bangledesh. If the Bangledesh supplier is unable to fulfill orders because of damage to its factory, the apparel company may suffer lost profits and incur additional expenses as it attempts to obtain fabric from other sources. Assuming the apparel company's property policy includes CBI and CEE coverage, it may be able to recover those losses from its own insurer, even though the property damage occurred to a third party's factory more than 8,000 miles away.

Now, assume that the apparel company sells its clothing to a major retailer, which cancels a significant order because of damage to one of its retail stores. Assume further that the order cancelation causes the apparel company to lose profits and incur additional expenses as it attempts to sell the clothing to a different retailer. The apparel company may have contractual remedies against the retailer, but may not want to sour the business relationship by exercising those remedies. Once again, if the apparel company has CBI and CEE insurance, it may be able to recover its losses from its insurer, without harming its business relationship with its customer.

Given the ripple effect of a single incident on the increasingly complex and vulnerable supply chain, insurers often fight hard to limit CBI and CEE payments. Here are five key things to know about CBI and CEE insurance to maximize coverage.

1. Triggering coverage
The biggest limitation on CBI and CEE coverage is that it typically only applies when a supplier or customer suffers physical damage to property. Creative arguments can be made regarding what qualifies as physical damage to property. For example, courts have found that contamination of property by vapors, bacteria or other foreign substances may qualify if the property is rendered unusable. Corruption of data may also qualify under certain circumstances. Although these cases are encouraging, courts remain cautious in their analysis of what constitutes physical damage to property.

The property damage at issue must also typically be caused by a peril that is covered by the policy. For example, going back to the hypothetical apparel company discussed above, assume that the Bangladesh factory was closed because soot from a fire caused by an earthquake rendered the factory unusable. Assume that the policy covered fires, but excluded coverage for earthquakes. An issue would likely arise as to whether the soot contamination was caused by the fire (a covered peril) or the earthquake (an uncovered peril). These nuanced causation issues regarding whether the loss is "contamination" caused by an "earthquake" as opposed to "property damage" caused by a "fire" could dramatically impact whether coverage is available.

2. Direct vs. indirect suppliers and customers
Another common issue is who qualifies as a "supplier" or "customer." Courts interpreting the scope of CBI and CEE coverage differ on the requisite relationship between the policyholder and the supplier or customer. As a result, many insurers now limit coverage to "direct" suppliers or customers. Some even limit coverage to specifically identified direct suppliers or customers. When purchasing CBI and CEE insurance, businesses should pay careful attention to these subtle distinctions to ensure that the most significant risks along their unique supply chains will actually be covered.

3. Total cessation of business vs. slowdown of business
Another issue that may arise is whether the policyholder must suffer a total cessation of its business or whether a slowdown or partial loss of profits is sufficient. The outcome of this issue largely depends on the actual policy language and the caselaw in the applicable jurisdiction interpreting the policy language. For example, some policies expressly cover a "slowdown or cessation" of business, while other policies are more limited or ambiguous. Once again, these distinctions should be considered when purchasing CBI and CEE coverage.

4. Calculating loss
Losses are typically limited to a hypothetical time period called the "period of restoration." The period of restoration usually begins on the date that the property damage actually occurred and ends on the date by which the property should reasonably have been repaired. Determining the period of restoration can be challenging because the end date may not be the date that the property was actually repaired or replaced. Rather, the relevant date is when the property could reasonably have been repaired or replaced. This inquiry is particularly challenging in CBI and CEE claims because the property at issue belongs to a third party, and is often located thousands of miles away, possibly even in another country.

The next step is calculating the lost profits and extra expenses during the period of restoration. Policies often specify the method for calculating lost profits and extra expenses. But, supporting those calculations can be challenging because the policyholder must demonstrate what would have happened had the supply chain issue not occurred. Maintaining thorough and accurate records of losses and expenses during the period of restoration is a critical step in the quantification process.

5. Filling in the gaps
While CBI and CEE insurance may help mitigate losses, certain supply chain disruption losses may fall outside of coverage, as discussed above. Specialty insurance products can fill some of those gaps. Such products include trade disruption insurance, supply chain insurance and marine cargo insurance. However, those products are less common, can be expensive and suffer from their own limitations and challenges.

Given the complexities of CBI and CEE claims and insurers' growing incentive to limit such claims, insurance recovery counsel should be involved early in the claim process to help navigate these and other issues to maximize a policyholder's insurance assets.

Tara Kowalski is a partner in Jones Day's Los Angeles office. Her practice focuses on representing policyholders in pursuing insurance claims and litigation.
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