Wide Area Damage: a Business Interruption conundrum

In previous Business Interruption articles I have suggested that less words provide more cover and that it is inadvisable to tinker with the basic UK Business Interruption policy formula that works so well.

Why do Business Interruption policies work so well? The answer is simple in that they provide a very flexible formula based on a measurement of the loss of sales of the business resulting from damage to the client's commercial property covered under the property policy. And what makes the formula so flexible? It's the Trends Clause (sometimes referred to as the Other Circumstances clause or the Bracketed Proviso), which states that the loss will be measured by a formula that will be adjusted to reflect what would have happened to the business results if the clients property hadn't been damaged.

So if the sales of a business had been running flat for the past 12 months, but were set to go through an imminent uplift brought about by a new product line, a new production facility coming on line, a future loss of a competitor or any other future circumstance benefitting the business, then that circumstance would justifiably be reflected in a business interruption claim calculation.

Similarly should the business be set for a decline, then that decline would also be justifiably reflected in the BI loss calculation.

The Trends Clause caters to seasonal businesses perfectly. For example, retailers would perhaps not expect peak sales in the middle of the year, but would certainly do so in November for the so called Black Friday sales and in December for the Christmas season. The Trends Clause is crafted to respond precisely to reflect what the business would have done but for the insured "Damage".

Business Interruption policy triggers

When a typhoon approaches Guam in its high season, the resorts in Guam will often stop accepting visitors for several days before the catastrophe is due to strike. There isn't at that point any damage at all and if the typhoon then veers away without impact, a reasonable man, upon studying his policy, would accept that there is no insurance claim to be made for the loss of business sustained, even though it was due to the presence of the typhoon event. It is an intended requirement of the standard UK Form of a Business Interruption policy that there must be indemnifiable "Damage" and that any reduction in sales must stem from that damage.

Confusion arises when a business interruption loss resulting from Damage to a client's property runs concurrently with the business interruption loss resulting from the typhoon or other natural catastrophe, because only the loss in consequence of the insured damage is covered and the loss brought about by the event itself is not.  

For example, where a typhoon actually strikes and a business luckily suffers only a broken window, but all around is devastated, the window can be repaired quickly and the doors reopened for business. The problem is that the surrounding devastation or wide area damage, results in a loss of attraction, which in turn causes visitor arrivals to fall, which affects the business, not to mention the attendant lack of power, the lack of transportation and infrastructure and the inability of staff to get to work. The damaged window, whether in a hotel or a factory probably has little or nothing to do with the fall in sales, but the surrounding damage, effects of media communication and adverse publicity will most certainly result in immediate cancellations and reduced business activity generally.

Is it possible to make a claim for the loss of business arising from a broken window? Yes of course, but not for the loss resulting from the decline in visitor arrivals to the area and the decline in trade brought about by that decline.

But what if the insured business assets are actually badly damaged or destroyed – does that change the picture? The answer here is no it doesn't. The event itself has caused the area to be disrupted and so the yardstick used to measure a business interruption policy's response can only be that of an undamaged business in an otherwise damaged area.

In short, under a UK standard Business Interruption form, the underwriter has charged a premium to insure the client's interest in agreed physical assets and any business interruption loss consequent upon the destruction of those assets. The underwriter has not charged a premium commensurate with insuring losses brought about by the effects of the nat-cat event over a wide geographic area.

NatCat damage examples

This effect was seen clearly in 2011 in the Christchurch earthquakes where the city centre was seriously damaged, the Thai floods where seven industrial estates were flooded in a lake the size of Switzerland for months on end and the Tohoku earthquake, which reduced the whole of the coastal region of north eastern Honshu to a standstill. More recently in September 2018 we saw Macau badly affected by Typhoon Mangkhut. However as the storm approached Macao the Government issued an Order that all Macau's casinos must close. This was done to ensure the safety of the public, but the order took effect before the typhoon arrived and was only lifted 33 hours later, during which the loss of revenue suffered by the gambling industry as a whole was said to have been of the order of USD 186 million. The standard BI policy would not respond to a business interruption loss that was not consequent upon insured damage and if you add to that the effect of the reduction in visitor arrivals because of the storm and its aftermath, there would clearly be a gap in the indemnity payable by insurers.

Historically wide area damage was an emotive topic with legal and insurance practitioner opinions falling either side of the argument that wide area damage effects should be factored out of any BI claim. A little more certainty was brought to bear by the judgement in Orient Express Hotels (OEH) V Generali SA 2011 which concerned the wide area damage effects of Hurricane Katrina on the Windsor Court Hotel in New Orleans in 2005.

The question of whether or not the devastating effects of Katrina on the area should be reflected in the anticipated sales of the business was decided in arbitration in favour of insurers. In other words the Business Interruption policy response was correctly reduced because "but for" the damage to the hotel, it would in any event have suffered from a downturn in business because it was situated in the devastated city of New Orleans. (Claims lodged under the sub-limited Loss of Attraction (LOA) and Prevention of Access (POA) clauses were however paid by Insurers without argument).

OEH appealed the decision of the Tribunal on legal grounds, contending that the result was unfair; that the loss concurrently caused by the event should also be insured since it was not specifically excluded and that the Trends Clause could not be used as a sort of policy exclusion, to introduce the effects of the wide area event to the detriment of OEH.

The Court held that the policy operated such that business interruption losses caused by Damage to insured property were recoverable under the main insuring clause (as is consistent with the Trends Clause). Other losses not caused by Damage (ie physical damage to the Hotel) but caused by damage to the City/lack of demand were recoverable under the LOA and POA extensions. That is what OEH paid the premium for under the policy and that was what the Tribunal held that OEH was entitled to recover.

This result may appear negative as far as a client is concerned but the reverse view may also be argued where as a result of an event and its wide area damage, prices on world markets rise and the client claims that but for the insured Damage he could have sold into that rise. Difficult territory indeed and highly dependent upon the facts of each case.

That is the theory and we now at least have some guidelines, but attendant difficulty inevitably arises in the loss adjustment exercise to determine what a reasonable adjustment is to cater for Wide Area Damage effects.

If we reflect on the Government Order issued in Macau, clearly that is a potential risk for the future and should perhaps be recognized in any business continuity planning exercise. In such cases it would clearly be a good idea to identify the potential magnitude of the risk in the loss scenario and flag it to the underwriter, requesting that cover be extended to cater for this risk. This is very simply done, provided of course the underwriter has the appetite for it and does not involve tinkering with the policy which is a bad idea. That produces contract certainty and curtails the risk of hypertension on both sides. Why make BI difficult – it is essentially all quite simple!

Parametric solutions and extending Business Interruption coverage

On the other hand, out of the wide area damage conundrum we have seen a recent growth of structured insurance products or so-called Parametric or Index-based insurance solutions. These may be arranged such that if a typhoon of an agreed intensity passes over an agreed geographical area and is verified by a set of agreed weather stations, the client, who will undoubtedly have suffered some damage, is entitled to a sum certain under the structured policy. Confirmation of damage is usually required, but a formal loss adjustment is unnecessary. This nicely circumvents any restrictions that may accompany a Trends Clause in a standard UK form Business Interruption policy.

Finally I would comment that I have referred to the UK standard Business Interruption form in this article – largely because in our conversations that is the form of cover that is used by risk professionals within corporate organizations. The same wide area damage rules may not apply to all US Business Income forms that are, in my opinion a little more challenging to interpret, vary in their lexicon and are indeed interpreted differently by various US State jurisdictions. There are a number of cases where a distinction is made between the word "damage" and the word "loss". But that is perhaps for another day!

Key Learnings

In this article we make the points that:

  • Standard BI policies are only triggered through physical damage to assets and/or property.
  • In devastating nat-cat events loss measurement, by virtue of the Trends Clause, is based on the expected performance of an undamaged business in an otherwise devastated area.
  • Some authority is provided by the case of Orient Express Hotels (OEH) V Generali SA 2011.
  • Talk to Underwriters or Brokers to extend cover simply and clearly to avoid post event disputes.


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