Contingent Business Interruption Coverage

by Scott E. Bushnell, CPA, CFF

The National Alliance of Insurance Education & Research / Spring 2012

In today’s business climate more focus is placed on lean operations. This trend is becoming increasingly more commonplace as corporations are divesting of business lines and re­turning to core competencies. As de­centralization continues to grow and corporations are relying on supply and sales agreements with non-relat­ed parties, the impact of a supplier or customer’s loss on a business’ opera­tions increases substantially. 

Contingent Business Interruption (CBI) insurance coverage is designed to protect a company’s earnings stream from the impact of key sup­plier or customers’ catastrophic loss­es. This form of coverage has unique characteristics when responding to a covered event, which puts additional challenges on a policyholder’s man­agement of a claim. However, risk managers who develop at least a basic understanding of CBI coverage, and how these policies respond to losses and CBI claim management, will find these claims less daunting and more manageable. 

Characteristics and Triggers of CBI Policies 

One legal definition of contingent business interruption insurance is, “an insurance policy that provides benefits if earnings are reduced be­cause of damages to another business on which one’s business is depen­dent.”1 As legal definitions go, this is actually a simple description of CBI coverage. Another way to describe CBI coverage is to relate the coverage to a company’s supply chain. This policy indemnifies the policyholder for lost earnings in the entire supply chain, from suppliers to manufactur­ers and customers. 

CBI is usually obtained as an ex­tension to Building and Personal Property poli­cies and will often in­clude contingent extra expense cov­erage as well. This coverage is not necessarily limited to any one type of policy, as equipment breakdown, HPR (Highly Protected Risk), international, marine, and manuscript policies can all include CBI language. 

One of the unique characteristics of CBI coverage is that losses arise from damage to a business that is not a par­ty to the insurance contract. In almost every other form of commercial insur­ance products, especially P&C polices, recovery for claims must result from damage caused to the policyholder’s property. The policyholder by its very nature is in a contractual relationship with the insurer. 

Additionally, CBI policies require that the event causing physical damage would have been a covered cause of loss under the policyholder’s insur­ance policy. This again is an unusual characteristic of CBI coverage—that a non-contractual party to the insuring agreement is being held to the stan­dard of the policyholder. 

Furthermore, the interruption to the policyholder’s business must be at a covered or scheduled location. Al­though this may seem obvious, plenty of claims have been denied or severe­ly reduced due to a non-scheduled lo­cation clause. 

For example, Company A, a covered location, has a sole source contract with Supplier B. Supplier B suffers a fire to its manufacturing facility, which causes an interruption of op­erations and results in the inability to fulfill its supply agreement with Company A. In order for Company A to recover losses under its CBI insur­ance coverage, it must have incurred an interruption of its operations due to a covered cause of loss. 

The period of indemnity for CBI claims is limited to the period of res­toration. This time period is usually described as the period from the time of loss until damaged property could have been repaired or replaced with due diligence and dispatch. In con­trast, Business Interruption (BI) may have slightly different language that allows for indemnity beyond the peri­od of restoration either as “operations returns to normal” or an extension of coverage. There is no such language for extended indemnity in standard CBI policies or coverage forms. 

There are two common forms writ­ten in the U.S. for CBI coverage: Dependent Property and Suppliers and Customers forms. Both of these forms contain the characteristics de­scribed above. Where they can differ is the identification of the party that is physically damaged. In the chain of liability, dependent property coverage is specific as to who is a supplier or customer. In contrast, CBI language is generally very broad as to who quali­fies as a supplier or customer. 

Dependent Property Broad Form 

The Dependent Property Broad Form identifies four specific groups an in­sured’s business is dependent on for its operations: contributing, recipient, manufacturing, and leader properties. Each of these groups provides specific coverage for the policyholder. In most cases an insured’s policy will likely contain one or two of these groups in its coverage. 

In the first three groups a direct rela­tionship must exist. This means that an arm’s-length business relationship between the policyholder and the de­pendant entity can be documented. An indirect relationship, such as a supplier’s supplier, would not trigger a claim even if all other conditions for coverage were present. 

Contributing Properties 

Contributing properties are those properties that provide direct goods and services to the policyholder’s op­erations. These properties are gener­ally direct suppliers of raw material, intermediate/finished goods, and re­lated services, such as freight for­warding. 

As an example, a petroleum coke pro­cessing company has a contractual re­lationship to receive all of the output of petroleum coke from an oil refin­ery. A lightning strike causes a cata­strophic explosion at the refinery. As a result of this incident, the refinery experiences an interruption of its op­erations and cannot supply petroleum coke to the pro­cessing com­pany. This in turn causes an interruption of business to the coke processor. In this instance the coke pro­cessing compa­ny’s insurance policy includes lighting strikes as a covered cause of loss. The coke pro­cessor can file a claim and re­ceive payment on its losses under contributing property CBI cov­erage. 

Recipient Properties 

Recipient properties are entities that receive direct goods or services from the policyholder. Generally, these are customers the policyholder relies upon to purchase its goods. Often there is a contractual relationship in place between the two parties. This coverage protects the policyholder’s earnings through its sales/distribu­tion chain. 

As an example, a flat screen monitor company sells finished component goods to a computer manufacturer that assembles components into fin­ished notebook computers. The com­puter manufacturer’s Midwestern as­sembly plant is severely damaged by a tornado and cannot receive compo­nents from the monitor company. The monitor company has an open perils policy that does not exclude tornados as covered cause of loss and files a CBI claim based on its lost sales to the computer manufacturer. 

Manufacturing Properties 

A company that has a direct relation­ship with a manufacturer that produc­es goods for the company is known as a manufacturing property. Often these goods will be shipped directly from the manufacturer to customers. Also, manufactured goods could be stored at a company or third party warehouse. The coverage that is af­forded protects the earnings generated through third party manufacturing. 

An example of this form of coverage is a U.S. company that sells plastic uten­sils, containers, and bowls to retail grocery and department stores. This company has all of its products man­ufactured in Taiwan by a nonrelated company. The manufacturer produc­es packages and ships the products to the company’s customers. A fire causes catastrophic damages to the manufacturer’s plant, which results in an interruption of the manu­facturer’s operations. The U.S. Company’s sales are interrupt­ed due to the manufacturer’s shut down; lost earnings can be analyzed and claimed un­der CBI manufacturing proper­ties coverage. 

Leader Properties 

Leader properties attract cus­tomers to nonrelated business­es. This type of CBI coverage is common in retail businesses. Consider, for instance, a large retail shopping mall with a single anchor store such as a high-end department store. Many of the shops located in the mall derive pass-through business from customers who came to the de­partment store and then shopped at other stores while at the mall. This pass-through traffic may be a consid­erable portion of a small retail shop’s business. 

An example of contingent business interruption might be that of a depart­ment store which experiences a major water pipe burst on the second floor, which results in the store shutting down for six months. This loss may cause a resulting decrease in sales for the small shop owner since the de­partment store is no longer attracting customers to the shopping mall. In this instance a shop owner may recov­er lost earnings under their coverage. 

Suppliers and Customers Form 

In contrast to the Dependant Proper­ties Broad Form, the Suppliers and Customers Form uses simple language in describing coverage. The following example is policy language from an Archer-Daniels-Midland Co. (“ADM”) Suppliers and Customers CBI insur­ance form. 

“This policy covers against loss of earnings and necessary extra ex­pense resulting from necessary in­terruption of business of the insured caused by damage to or destruction of real or personal property, by the perils insured against under this policy, of any supplier of goods or services which results in the inabil­ity of such supplier to supply.”

This specific language was the subject matter of a coverage dispute between ADM and its insurer Phoenix Assur­ance Company.3 The dispute arose over denial of coverage for CBI losses related to the 1993 flooding along the Mississippi River. ADM filed claims based on the interruption of operations for “Midwest Farmers” and the “U.S. Army Corp of Engineers” as its suppli­ers. The reason, ADM argued, was that the farmers supplied grain to brokers who sold grain to ADM’s processing plants. As for the Corp of Engineers, ADM reasoned that maintenance of the Mississippi River was a service provided to ADM. It is very likely that these two examples were beyond the intended scope of coverage. 

What is remarkable about this case is that the judge ruled in favor of ADM on both of these issues. The very broad interpretation of this policy lan­guage opened potential unforeseen liability for underwriters. It is under­standable that this particular form of coverage is declining in the U.S. 

Managing CBI Claims 

Most risk managers are familiar with standard business interruption insur­ance policies. It may stand to rea­son that many risk managers would consider CBI the same as a BI claim. The only difference is the damage to a noninsured party. Although this is essentially correct, there are substantial issues that are unique to CBI claims. Risk managers should take an active approach to managing these claims, especially with identifying the incident, documenting the claim, and proving the loss. 

The first step in any claim situation is to conduct a thorough policy review to determine coverage, ex­clusions, and the specific form of the loss calculation. It is im­portant at this stage to get your agent/ broker involved in the policy review. They should have an in-depth un­derstanding of the specific language and intent for coverage. Risk manag­ers may also have general or outside counsel that is familiar with P&C in­surance policies assist in the policy re­view. On most significant claims, risk managers will hire forensic accoun­tants to advise on relevant language dealing with quantifying the claim and calculating loss earnings. 

Identifying the Incident 

For risk managers, identifying the in­cident is an intuitive process of link­ing the incident to a covered loss. The method used to determine this relationship is the “chain rule.” Sim­ply stated, the following items must be linked together: physical damage to property, of a supplier, customer or dependant property, for a covered cause of loss, causing an interruption of business, during the policy term, in absence of exclusions, and in excess of deductibles. 

CBI losses pose several unique chal­lenges when applying the chain rule. Since CBI losses are incidents causing damage to an unrelated party, notice of the event to the CBI policyholder may be delayed. Even when notice is given immediately after a loss in­cident, details of the loss may not be communicated in a complete fashion. Here lies the first major hurdle of identifying the incident. 

Notice 

Communication between the CBI policyholder and the damaged party is critical to understanding the impact of the incident on current operations. The damaged party usually experienc­es at least some confusion in respond­ing to the incident. A communication plan between the CBI policyholder and the damaged party is an excellent means of sharing information. Having a communication plan in place be­fore a loss incident occurs allows for streamlined communication after the initial incident occurs. 

In the best circumstances a commu­nication plan identifies the nature of incident, immediate impacts to both parties, and initial steps to recover from the incident. This plan can be as simple as a formatted e-mail, memo, or letter contain­ing the following items. 

• Time, place, and location of the incident 

• Peril that caused the incident (fire, explosion, equipment breakdown, etc.) 

• Immediate impacts to the damaged party (plant, property, or equipment) 

• Remedial action of damaged party 

• Anticipated or estimated period of restoration 

These five items will generally pro­vide enough information to identify the incident and determine if it falls within the chain rule. 

Determining the Period of Recovery 

After notice of the incident is given to the CBI policyholder and their insur­er, the next issue will be identifying the period of recovery. This step also poses its own set of hurdles. Exactly how long it will take to rebuild a dam­aged facility and to what extent, can be questions that are open to much interpretation. One of the first con­siderations for the period of restora­tion is determining the length of time for rebuilding. This may seem a very straight-forward question; however the answer can be difficult to state. 

Consider, for instance, a 40-year-old manufacturing plant that suffers a sig­nificant explosion that causes exten­sive damage to the facility. Most in­surance policies require the rebuilding to be of like kind and quality as the original plant. In a replacement cost policy this is old for new construction cost. Over the last 40 years there may have been significant change that has not been previously incorporated into the plant. How do items such as code upgrades, changes in technology, and expansions to the original facility af­fect the period of restoration? 

In this case it is imperative that suf­ficient information on the recovery effort is communicated to the CBI policyholder. If the damaged party decides to perform a plant expansion along with the insurance recovery construction can those costs be seg­regated? If the plant expansion adds additional time to the actual period of restoration, that additional con­struction time will have to be identi­fied and excluded from the period of restoration. Additionally, the original construction timeline may have been aggressive on minimizing the amount of time to rebuild. Consideration must be given to reasonable delays in con­struction that may increase the period of restoration. 

One of the best practices for this situ­ation is the damaged party allowing plant tours for the CBI policyholder and their adjuster during the recov­ery period. This facilitates open com­munication and speedy recoveries for both parties. Non-disclosure agree­ments can be signed by all of the in­terested parties to protect sensitive information or documentation. 

Documenting a CBI Claim 

One of the biggest keys to manag­ing CBI claims is documenting the loss. This may seem simple enough; however, as seen above, there are ad­ditional facts and circumstances that need to be recorded beyond a normal BI claim. 

During the period of restoration a CBI policyholder may be faced with a tim­ing difference between the actual date of loss and the point at which it ex­periences an interruption of its opera­tions. For example, a chemical proces­sor supplies a refined raw material to a customer at a contracted price and volume. The customer experiences a catastrophic explosion and its pro­cessing plant is shut down. However, the customer can still receive raw ma­terial from the supplier. 

The customer may continue to receive raw material for several months un­til its inventory storage is full. The supplier would not suffer an inter­ruption of its business until the cus­tomer stopped receiving raw material. Consequently, the supplier’s period of indemnity would be reduced to the point at which the customer stopped receiving material until the damaged plant was restored. Situations such as this need to be adequately document­ed through correspondence and other communication between the suppler and customer. 

Under P&C policies there is a duty to mitigate losses. With CBI claims, mitigating losses may prove to be dif­ficult or unusual. Take or pay and sole source contracts with suppliers and customers may put a CBI policyholder in a tremendous bind. If the industry in which the CBI policyholder oper­ates has only a few major customers that generally deal only with contract­ed suppliers, there may be no alterna­tives to sell their products. Secondary and tertiary markets may also have to be explored. 

Often, secondary and tertiary markets will purchase at a much lower price than a primary market. Even though a CBI policyholder may make some sales it would have otherwise lost, those sales may be made at a loss. Documenting a circumstance such as this will become critical when explain­ing why certain actions were or were not taken by the CBI policyholder. 

Additionally, the CBI policyholder should maintain documents related to their specific industry, especially historical and forward looking trends in the market place. The policyholder will have to work closely with the ad­juster on their specific industry. Exter­nal market reports and analysis is an excellent tool to provide an indepen­dent view of the market place. Provid­ing this information to claim consul­tants and the adjuster will facilitate an efficient claim process. 

Proving the Loss 

When due consideration is given to documenting CBI claims, proving the loss becomes considerably easier. Just as in a normal business interrup­tion claim, there are several issues that should be addressed in the CBI claims: appropriate modeling of ex­pected versus actual performance dur­ing the period of the loss, and efforts of mitigating losses and incurred extra expenses. In some cases the insured should consider the cost benefit of hiring forensic accountants to prepare these claims. Forensic accountants are uniquely qualified to assist in these matters and provide an overwhelming benefit when it comes to analyzing and defending CBI claims. 

Regardless of the form of a CBI claim, an historical analysis of the income statement is performed. This analysis takes into consideration past perfor­mance of the business. Historical sales revenues and volume are analyzed to determine trends and seasonality. In CBI claims this will generally focus on the individual supplier, customer, or dependent property that is the subject of the loss. 

Sales and revenue analysis should also include a review of significant contracts between the parties. In most cases, contract reviews provide qualitative information as to perfor­mance issues and costs and volumes purchased or supplied. Relationship analysis, such as price to volume or cost plus, may provide pertinent in­formation considered in analyzing and modeling expected operations. Additionally, historical minimum and maximum volumes purchased or sold will give insight into expected sales. 

The next step in proving the loss is analyzing cost of sales, either as cost of goods sold or cost of goods manu­factured. If the damaged company is a supplier, due consideration should be given to any contracts in place be­tween the two parties. Specifically, supplier side CBI claims may involve contracts that are indexed to market pricing for raw materials. This can have a significant impact on deter­mining gross margins. For example, if the cost of raw materials is indexed to a market that is decreasing in cost while the finished goods are increas­ing in sales price, the impact of the loss may be greater than a historical average may indicate. 

One of the most difficult parts to prov­ing out the claim is determining con­tinuing and discontinuing expenses. As a general rule, any expense that continues to be incurred during the period of restoration is a continuing expense. This is a straight-forward definition, and the converse is also true—those expenses that are not in­curred during the period of restoration would be discontinuing expenses. 

But what happens if continuing ex­penses do not continue at the same rate as pre-loss? This condition is very common in CBI claims, and since the policyholder has an obligation to miti­gate its losses there could be fluctua­tions in expenses due to a partial shut­down of operations. In this instance, the analysis of continuing/discontinu­ing expenses should address partially continued or discontinued expenses. 

Since CBI claims are generally focused on one significant supplier, customer, or dependent property, the business interruption claim may be segregated to that one entity. If that is the case it may be beneficial to the CBI poli­cyholder to hire a forensic accountant to assist with preparing the claim. Segregating sales, costs, and expenses to a single entity requires a firm un­derstanding of accounting. As is often the case, not all expense may be at­tributable to a single entity. Thus, the expenses will have to be analyzed to determine the relevant portion to be allocated to the claim. 

Working through the Challenges 

In the end, CBI claims have the same goal of any other commercial claim— putting the policyholder back in the position it would have been had no loss occurred. There is a consider­able amount of analysis that must be performed to determine what that position would have been. However, through utilizing good communica­tion with the damaged party, docu­menting all of the facets of the loss, and proving damages, risk manag­ers will find that these claims can be managed. 

It is quite likely that CBI claims will continue to increase as businesses decentralize and enter into long term contracts with suppliers and cus­tomers. Being knowledgeable about these claims will benefit the parties involved in providing the right cover­age, as well as the process involved in managing a claim in the event of a loss.