Ensuring Service Interruption Coverage
Insurance Law360September 18, 2012
By Seth V. Jackson
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By many estimates, some 670 million people, or almost 10 percent of the world’s population, lost power during the recent electrical outage in India. Although the United States has never experienced such a massive power failure, there have been real-life examples of widespread electrical outages such as the four-day blackout as a result of a major grid collapse in August 2003, which affected over 50 million people in the northeastern United States and Canada with an estimated economic cost between $4 billion and $10 billion.[1]
More recently, states along the eastern seaboard, particularly in New England, and three Canadian provinces suffered widespread power outages as a result of the 2011 Halloween nor’easter. Heavy, wet snow and wind-downed trees that were still in leaf caused unprecedented damage to power lines. Over 3,000,000 customers lost power, with over half of whom experiencing outage for at least three days. Connecticut was hit especially hard where 830,000 people lost power, many for up to 10 days.
Although regional outages from natural disasters such as hurricanes, earthquakes and blizzards occur with some regularity, there is increasing concern about the potential for even more catastrophic outages from terrorism, cyber attacks or solar storms.
For an economy such as the U.S., the potential impact extends well beyond the loss of electrical power. Other utility services such as water, natural gas, sewer, telecommunications and the Internet can be interrupted. The disruption to individuals and businesses and the resulting economic cost can be huge. While the U.S. has so far escaped, the India blackout is a stark reminder for insureds and insurers of the importance of “service interruption” coverage for such events and of some of the issues and lessons relating to this coverage.
Commercial property insurance policies typically exclude loss or damage caused by interruption of incoming utility services. However, extensions of coverage for “service interruption” are available for damage to property at insured premises and for loss due to interruption of the insured’s business that results from an interruption of utility services.
In order for “service interruption” coverage to apply, the following elements must be met: a covered peril or cause of loss; resulting physical damage to off-premises utility property that interrupts the utility service; physical damage to the covered property on the insured’s premises or a necessary interruption of the insured’s business operations because of the lack of utility services; and with respect to business interruption, an actual financial loss — generally, lost profits and continuing expenses that would have been earned out of operations had the interruption not occurred and extra expenses incurred by the insured’s business to continue operations during the outage period.
In addition to these basic requirements, many policies contain other terms and conditions intended to manage the overall exposures presented by service interruptions. Sub-limits are fairly routine. Waiting periods — a type of deductible where coverage does not attach until the outage exceeds a specified time period, e.g. 24 hours — are often used to avoid coverage for short-term outages.
Transmission and distribution (T&D) lines present unique risks. Some policies exclude coverage altogether for service interruption due to damage to T& D lines. Other policies may provide limited coverage only when the damage to T&D lines occurs within a specified range, e.g. 1,000 feet, of the insured’s premises. Satellites are another typically excluded category of property. Interruption of Internet or intranet and wireless communications is another category of exposure which is specially underwritten.
Damage to off-premises utility equipment from a hurricane or winter storm is relatively easy to establish, and claim issues usually center on quantification of the loss and the application of sub-limits and deductibles. However, a general widespread outage unattached to a natural catastrophe, such as one that may occur as a result of a latent computer virus or cyber attack, presents more difficult coverage issues in terms of establishing that the service interruption resulted from physical damage to off-premises utility property from a covered cause of loss.
This was the key question in Wakefern Food Corp. v. Liberty Mut. Fire Ins. Co., 968 A.2d 724 (N.J. Super. Ct. App. Div. 2009). In Wakefern, Liberty Mutual Fire Insurance Company denied coverage to Wakefern Food Corporation, whose member supermarkets suffered food spoilage losses and loss of business during the four-day electrical blackout that affected much of the Northeast in August 2003.
At issue was a service interruption coverage extension in Wakefern’s first-party, all-risk insurance policy which provided coverage for consequential loss or damage resulting from an interruption of electrical power to Wakefern’s supermarkets caused by “physical damage” to certain off-premises electrical equipment and property. The term “physical damage” was not defined in the policy.
On appeal, the Superior Court of New Jersey reversed and remanded, holding that the undefined term “physical damage” was ambiguous in the context of that case. The court found no basis to require that the physical damage to the electrical grid had to be permanent.
The court rejected Liberty Mutual’s argument that since the power grid was only temporarily incapable of providing electricity, there was no “physical damage” under the policy, and coverage was barred. Rather, the court reasoned that the electrical grid was “physically damaged,” even if only on a temporary basis, because the grid and its component parts were physically incapable of performing their essential function of providing electricity and enabling the refrigeration of food — the precise risk Wakefern believed it had successfully insured against.
Wakefern provides notice that the basic requirements of the “service interruption” coverage need to be understood and that all key terms are defined clearly and unambiguously in the policy.
However, the case of Red Bird Egg Farms Inc. v. Pennsylvania Mfrs. Indem. Co., 15 Fed. Appx. 149 (4th Cir. 2001) teaches an even more valuable (and simple) lesson — make sure the policy contains “service interruption” coverage in the first place if the business is heavily dependent on a utility service.
In Red Bird, the insured’s primary business was the production of chicken eggs. Its chicken houses needed constant ventilation for the chickens to survive. Accordingly, Red Bird employed an extensive system of electric ventilation fans, which required three-phase alternating current to operate correctly.
A lightning strike outside Red Bird’s property interrupted electrical service to the farm. When the utility-supplied power was interrupted, Red Bird’s backup generator automatically engaged. Unfortunately, the generator failed shortly thereafter because of a ruptured coolant hose. As the insured was trying to fix the generator, the electric utility restored power. However, instead of three-phase, the power company restored only single-phase power, which caused the motors in approximately 100 of the insured’s ventilation fans to burn out. Without the fans, approximately 500,000 chickens died.
The insurer paid approximately $1 million for the loss of the birds, the damaged generators and debris removal, but it denied Red Bird’s business interruption claim under an exclusion for “(a)ny loss caused directly or indirectly by failure of power or other utility service supplied to the described premises, however caused, if the failure occurs outside of a covered building.”
The Fourth Circuit Court of Appeals in Red Bird upheld the lower court’s finding that the single phasing was the equivalent of a power interruption which fell within the meaning of the policy exclusion.
More recently, courts around the country have begun to grapple with “service interruption” coverage on a variety of other fronts. For example, a Texas federal district court in All Metals Inc. v. Liberty Mutual Fire Insurance Company, No. 3-09-CV-0846 (N.D. Tex. 2010) held that damage to a rotary furnace following a thunderstorm-related power outage at a metal recycling facility was a single occurrence.
Liberty Mutual paid the $500,000 limit of liability under the Services Interruption Coverage Extension endorsement. All Metals claimed that damage to the furnace shell, electrical wiring and insulating brick during reheating the furnace and further damage while curing the new insulating brick was the result of two other occurrences and that it was entitled to $3 million in additional losses. The court found that all of the claimed damage was attributable to the power outage; thus, there was only one occurrence under the policy.
Additionally, the Kings County Supreme Court in Brooklyn, N.Y., in Fruit and Vegetable Supreme Inc. v. The Hartford Steam Boiler Insp., 28 Misc.3d 1128 (Sup. Ct. 2010) held that any food spoilage and resulting loss of income arising from the 2003 blackout were not recoverable because the cause of the blackout (“tripping off line”) was excluded under the services interruption coverage. However, damages that were sustained by an unrelated covered loss just prior to the blackout were recoverable because the losses could be “compartmentalized into those suffered pre and post blackout.”
While extended outages are infrequent in the United States, the blackout in India should nevertheless prompt both insureds and insurers to revisit how they are approaching interruptions of utility services. Insureds should assess the extent to which their business operations rely on electricity, water, fuel, sewer, telecommunications or the Internet and tailor their insurance coverage and contingency plans accordingly.
Are all potential causes of service interruption adequately addressed? Is the physical damage requirement unambiguous? As with any insurance policy, key terms and coverage requirements should be clear and understood so that they can be applied without controversy should a loss occur.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] U.S. - Canada Power System Outage Task Force, “Final Report on the August 14, 2003 Blackout in the United States and Canada” (April 2004)
