Fallout from the Japan Disaster:Causation & Aggregation IssuesUnder CBI & Reinsurance Policies

Darlene K. AltPartner

Providence, RI

James T. KilleleaAssociate

New York, NY

Nathan HullAssociateLondon

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Agenda

Background of Japan Disaster

Contingent Business Interruption (CBI) Insurance

• Causation Principles

• Affect of Anti-Concurrent Causation Clauses on SupplyChain Losses

• Damaged Property in Damaged Area: Orient-ExpressHotels Case

Aggregation Principles under Reinsurance Policies

• Event-Based Wording and Hours Clauses

• Application of Aggregation Principles to Japan Disaster

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Background: The Disaster Unfolds

March 11, 2011 9.0 magnitude earthquake

Minutes later, a 33-foot tsunami traveled 6 milesinland

Series of aftershocks

Total economic loss: $300 billion

• Insured loss: $50 billion

• Reinsured loss: $20 billion

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Background: Key Industries Disrupted

Semiconductors

• 20% of world’s total production

• 45.1% of global production for consumer electronics

• 31.5% of global production for automotive electronics

Electronics

• 35% of the global flash memory market

Automotive

Shipping

Energy

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Contingent Business Interruption (CBI)Insurance

Shortage of component parts manufactured inJapan disrupts supply chains worldwide

Claims for coverage of lost profits and otherexpenses from supply interruptions

• Failure to obtain component parts

• Inability to ship product to consumers

Business Interruption coverage (BI) v. CBIcoverage

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CBI Coverage: Overview

Typically, added by endorsement

Standard Insuring Clause:

“We will pay for the actual loss of Business Income yousustain due to the necessary suspension of your operationsduring the ‘period of restoration.’ The suspension must becaused by the direct physical loss of or damage to ‘dependentproperty’ at a premises described in the Schedule caused byor resulting from any Covered Cause of Loss.”

(ISO Form CP 15 08 10 00)

“Business Income” defined to include net profit (or losses)that would have been realized and the continuing normaloperating expenses incurred.

May include coverage for extra expenses

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CBI Coverage: Causation Requirement

Insured’s loss caused by direct physical loss or damage todependant property caused by a covered peril

Dependant Property

• Contributing property

• Recipient property

Direct v. indirect supplier

Two prong causation requirement:

• Physical loss or damage to supplier’s property caused by aninsured peril; and

• Loss of income by insured caused by the physical damage

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CBI Coverage:Potential Causes and Losses

Potential Causes

• Earthquake

• Tsunami

• Flooding

• Nuclear radiation

• Power outages

• Aftershocks

• Evacuation

Typical Losses

• Lost profits

• Expenses forreplacement materials

• Labor and relocationcosts

• Liquidated damages

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CBI Coverage:Time and Scope Limitations

Lost income insured would have earned during“period of indemnity” or “restoration period”

Time necessary to rebuild, repair or replace thedamaged property with "reasonable speed" or"due diligence”

• 72 hours after damage incepts

• Length of indemnity period varies

Specific property locations

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CBI Coverage: Exclusions

Common Excluded Perils

• Earth Movement – Earthquake, including any earthsinking, rising or shifting related to such event

• Water – Flood, surface water, waves, tides, tidalwaves, overflow of any body of water, or theirspray, all whether driven by wind or not

• Nuclear Hazard – Nuclear reaction or radiation, orradioactive contamination, however caused

• Pollution- discharge, seepage, release or escape ofpollutants

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Causation Doctrines:Efficient Proximate Cause

Prevailing approach in U.S.

If a covered and excluded risk cause a loss, coverageexists only if the covered risk was the efficient proximatecause of the loss

Definition varies widely

• Dominant, efficient cause that sets the other causes in motion

• Predominating or moving efficient cause

• Superior strength, influence, authority or position

• Primary cause

Doctrine does not apply where completely independentcauses simultaneously produce an indivisible loss

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Application of theEfficient Proximate Cause Doctrine (EPC)

Julian v. Hartford Underwriters Ins. Co., 35 Cal. 4th 747(Cal. 2005):

• Rain and landslide contributed to property damage

• Policy contained a weather conditions exclusion

• Because the landslide was the EPC of the damage and it wasan excluded peril (weather conditions), no coverage for theloss

Western National Mutual Ins. Co. v. UND, 643 N.W.2d 4(N. Dak. 2002):

• Flooding and sewage contributed to property damage

• Flooding exclusion in the policy

• Because the excluded peril (flooding) was not the EPC,coverage provided by the policy

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CBI Coverage: Scope of Recovery

Generally, the whole loss is recoverable as long asthe covered peril is the efficient proximate cause ofloss

Some courts limit coverage to only those damagesproximately caused by the covered peril

• State Farm Fire & Cas. v. Slade, 747 So.2d 293 (Ala.1999) (coverage only allowed for damages proximatelycaused by lightening, a covered peril)

• State Farm Fire and Cas. Co. v. Rodriguez, 88 S.W.3d313 (Tex. App. 2002) abrogated on other grounds by267 S.W.3d 20 (Tex. 2008) (where plumbing leakscontributed to 25% of loss and were covered by policy,insured recovery limited to 25% of the loss)

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Causation Doctrines:Concurrent Causation

Minority approach in U.S.

Generally applies where completely independentcauses simultaneously produce an indivisibleloss.

Loss is wholly covered as long as at least onecovered peril, independently or dependently,contributed to the loss

• Expansive approach

• Favors policyholders

Burden of proof varies

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Anti-Concurrent Causation (ACC)Clauses

Began appearing in policies in early 1980s inresponse to losses arising from HurricaneCamille

Contracts around the causation doctrines

Typical provision:

• “We will not pay for loss or damage caused directlyor indirectly by any of the following. Such loss ordamage is excluded regardless of any other causeor event that contributes concurrently or in anysequence to the loss.”

Intended to bar coverage where an excludedperil is one of two or more causes of a loss

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Enforcement of ACC Clauses

Enforcement varies widely

• Applied in approximately 20 states

• Gulf Coast state courts tend to enforce ACCclauses

Many courts that apply the concurrent causationdoctrine enforce ACC clauses

Rationale for enforcement

• Freedom of contract

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Enforcement of ACC Clauses

Non-enforcement jurisdictions

• California

• West Virginia

• North Dakota

• Washington

Rationale for non-enforcement

• Contravenes state valued policy statutes

• Contrary to public policy

• Conflicts with reasonable expectations of insured

Where multiple independent causes result in a loss, ACCclause may not apply

• See, e.g., Corban v. United service Auto. Ass’n, 20 So.3d 601(Miss. 2009)

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Interpretation of ACC Clauses

Courts split on whether ACC clauses unambiguous

Courts enforcing ACC clauses generally find themunambiguous

• Favors insurers

• Tuepker v. State Farm Fire & Cas. Co., 507 F.2d 346 (5th Cir.2007) (applying Mississippi law)

If ambiguous, generally interpreted in favor of insureds

• In re Cameron Parish Rita Litigation, 2007 WL 2066813 (W.D.La. 2007 (applying Louisiana law)

• St. Mary’s Area Water Authority v. St. Paul Fire & Marine Ins.Co. 464 F. Supp. 2d 397 (M.D. Pa. 2006)

• Brooklyn Bridge, Inc. v. South Carolina Ins. Co., 309 S.C.141, 420 S.E.2d 511 (Ct. App. 1992)

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CBI Claim Considerations

Examine the policy, the covered and excluded perilsand whether policy includes an ACC clause

Analyze the interplay between covered, non-coveredand excluded perils contributing to the loss

Determine which state’s law governs

• What causation doctrine applies?

• Does the jurisdiction enforce ACC clauses?

Insurers generally have greater exposure where:

• Courts apply the concurrent causation doctrine

• Courts refuse to enforce ACC clauses

• Courts find ACC clauses ambiguous or inapplicablebecause of multiple independent causes

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CBI Coverage for Japan Losses

Two “causes” involved

• physical damage to supplier’s property caused by an insuredperil; and

• loss of income by insured caused by the physical damage.

Japan: damage to supplier’s property as well severedisruption:

• Damaged road and rail networks

• Damaged seaports

• Power shortages and blackouts

• Exclusion zones

Loss of income caused by physical damage tosupplier’s property or one or more of thecircumstances above?

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CBI Coverage:English Approach to Causation

English law: “proximate cause” of loss

If two or more concurrent proximate causes,coverage for the loss caused will depend onwhether one of the causes is excluded asopposed to merely uninsured. (Wayne Tank &Pump Co. v. Employers’ Liability AssuranceCorporation CA [1973] Lloyd’s Rep. Vol.2).

Under US state laws, prevailing approach applies“efficient proximate cause” doctrine.

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Damaged Property in Damaged Areas

Losses caused by both damage to the supplier’s propertyand damage to the surrounding area.

Orient-Express Hotels v. Assucurazioni Generali SA[2010] EWHC 1186 (Comm).

• Issue: Whether luxury hotel in New Orleans was covered for“loss due to interruption… with the Business directly arisingfrom Damage.”

• Policy provided that losses were to be adjusted so that theyrepresented “the results which but for the Damage wouldhave been obtained during the relative period after thedamage.”

• Hotel damaged by hurricanes Katrina and Rita and forced toclose. During that time New Orleans was subjected to a stateof emergency, a curfew and two mandatory evacuations.

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Damaged Property in Damaged Areas (cont.)

Damage to hotel and damage to New Orleansconsidered independent proximate causes of BIlosses to hotel.

“But for” test applied

“undamaged hotel in damaged city” scenario

Court found that losses would have been thesame due to devastation in New Orleans and didnot allow recovery under policy.

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Lessons from Orient-Express Hotels

Decision reached on basis of specific “but for”language in policy

Insurers likely to rely on Orient-Express Hotels

Important for insured and insurers to carefullycheck:

• Extent of any CBI coverage

• Law governing policy

• Applicable exclusions

• How losses are assessed

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Aggregation Principles UnderReinsurance Policies

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Reinsured Losses

Ultimate potential loss for reinsurers: $20bn

Resulting from: shake and fire property losses,tsunami onshore property losses, tsunami on thecoast property losses, BI and CBI losses

Reinsurances affected:

• Residential property

• Commercial and industrial property

• BI

• CBI

• Not clear to what extent property damage and BI lossescaused by earthquake and tsunami will be covered.

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Key Facts Relating to Aggregation

Aggregation important to reinsurance policies inrelation to the retention and limits of coverage

9.0 magnitude earthquake

Tsunami

Aftershocks

Fires at industrial plants

Exclusion zone

Power shortages and blackouts

General devastation including damage toinfrastructure

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Reinsurance: Aggregation Principles

No general principles applicable to each andevery case

Turns on specific policy wording

Most common types of wordings

• Event-based wordings

• Hours clauses

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Event-Based Wordings

“Each and every loss and/or series of losses arising out ofone event”

Sometimes “occurrence” used instead of “event” butinterchangeable unless contract requires some distinction.(Kuwait Airways v. Kuwait Insurance Co. SAK [1996] 1Lloyd’s Rep 664 (QB Com CT)).

“arising out of one event” has been interpreted asrequiring:

• Common factor which can properly be described as an event;

• A test of causation must be satisfied; and

• The event does not have to be the proximate cause of theloss but it must not be too remote (B.F. Caudle & Others v.Alec Sharp & Others [1995] LRLR 433 CA).

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Event-Based Wordings (cont.)

“Unities test” provides that event or occurrence involvesthe question of degree of unity in relation to:

• Cause;

• Locality;

• Time; and

• If initiated by human action, the circumstances and purposesof the persons responsible. (Kuwait Airways v. KuwaitInsurance Co. SAK [1996] 1 Lloyd’s Rep 664 (QB Com CT)).

• “An event is something which happens at a particular time, ata particular place, in a particular way… A cause is somethingaltogether less constricted. It can be a continuing state ofaffairs; it can be the absence of something happening…”.(Axa Reinsurance (UK) plc v. Field [1996] 2 Lloyd’s Rep 233(HL)).

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Hours Clauses

“each and every loss occurrence” where “lossoccurrence” defined as

• “…all individual losses arising out of and directlyoccasioned by one catastrophe. However, theduration and extent of any ‘loss occurrence’ sodefined shall be limited to…

72 consecutive hours as regards:

(a) Hurricane, typhoon, windstorm, rainstorm, hailstormand/ or tornado

(b) Earthquake, seaquake, tidal wave and/or volcaniceruption

(c) Within the limits of one City, Town or Village asregards riots, civil commotions and maliciousdamage…”

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Hours Clauses (cont.)

(d) individual loss or losses included in any of the individualloss or losses from the perils mentioned in (a), (b) and (c)above…

168 Consecutive hours as regards any “loss occurrence” ofwhatsoever nature which does not include individual loss orlosses from any of the perils mentioned in (a), (b) and (c)above…

…and no individual loss from whatever Insured peril, whichoccurs outside these periods or areas, shall be included inthat “loss occurrence”…

• The [Reinsured] may choose the date and time when anysuch period of consecutive hours commences and if anycatastrophe is of greater duration than these periods, the[Reinsured] may divide that catastrophe into two or more “lossoccurrences”, provided no two periods overlap and providedno period commences earlier than the date and time of thehappening of the first recorded individual loss to the[Reinsured] in that catastrophe.” [LPO98a].

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Hours Clauses (cont.)

No English case law on meaning of hoursclauses

Key points to note:

• Losses must arise out of and be directlyoccasioned by one catastrophe

• “catastrophe” is not defined

• “catastrophe” and “peril” may be different, and theformer can arise from one or more of the latter

• In other examples of hours clauses catastrophe isdefined as a “sudden violent physical operation andone and the same manifestation of an originalinsured peril [and certain reinsured perils]” (LIRMANP61)

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Hours Clauses and the IUA

IUA review in November 2009:

Earthquake: “sudden release of energy in the Earth’s crustwhich creates seismic waves…and shakes the land (asopposed to the ocean floor) as a result of this release ofenergy and can extend for miles around the epicenter”.

Seaquake: “a sudden release of energy in the Earth’scrust, which shakes the ocean floor…and can extend formiles around the epicenter”.

Tidal wave: “the swell or crest of surface ocean watercreated by naturally occurring tides”.

Tsunami (not a named peril): “a series of water waves thatis caused when a large volume of a body of water, suchas an ocean, is rapidly displaced. This displacement canoccur as a result of a seaquake, earthquake and/orvolcanic eruption”.

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Hours Clauses and the IUA (cont.)

IUA: “with regard to tsunamis, it might be worthnoting that if a seaquake, earthquake and/orvolcanic eruption set in motion an uninterruptedchain of events leading to a tsunami, thecatastrophe would already be catered for by theclause”.

If losses resulting from tsunami not consideredas “directly occasioned” by earthquake thenlosses will be subject to a 168 hour (7 day) timelimit, rather than a 72 hour time limit

“Aftershocks” from earthquakes and seaquakescould be expected to be part of samecatastrophe as original earthquake or seaquake

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Aggregation Issues(Event-Based Wordings)

Ultimately depends on particular wording of thepolicy

Issues:

• Do earthquake and tsunami constitute the sameevent?

• Do the aftershocks constitute the same event asthe original earthquake?

• Can losses from power shortages/blackouts relateback to the earthquake or tsunami?

• Can losses from exclusion zones relate back to theearthquake or tsunami?

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Aggregation Issues (Hours Clauses)

Issues for Hours Clauses:

• Which losses were directly occasioned by onecatastrophe?

• Japan earthquake an “earthquake” or a “seaquake”or both?

• Japan earthquake and tsunami one catastrophe?

• Aftershocks within the original earthquake?

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Aggregation underReinsurance Policies in the U.S.

Reinsurance law is still developing

No reported U.S. case law interpreting whatconstitutes an “event” or “cause” for reinsurancepurposes

U.S. authorities have not formulated a single test

• However, usually a “cause oriented” analysis

Courts tend to focus on meaning of key terms:

• “series of accidents”, “arising out of one occurrence”,“common origin”, etc.

Resolution of aggregation issues turns on languageof reinsurance contract and applicability of “Followthe Fortunes”

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Definition of“Series” in Context of Aggregation

Common sense construction

Travelers Casualty and Surety Co. v. Certain Underwritersat Lloyd’s (N.Y. 2001)

• Reinsurers refused to follow cedent’s treatment of paymentsmade as a result of contamination at multiple pollution sitesover many years as “one loss”

• Court upheld reinsurers’ position based on following contractlanguage:

“Loss” was defined as “all loss arising out of any one disasterand/or casualty”

“Disaster and/or casualty” was defined as:

“All loss resulting from a series of accidents, occurrencesand/or causative incidents having a common origin and/ortraceable to the same act, omission, error and/or mistakeshall be considered to have resulted from a single accident,occurrence and/or causative incident”

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Definition of “Series” (cont.)

Travelers Casualty and Surety Co. v. CertainUnderwriters at Lloyd’s (N.Y. 2001) (cont’d)

• Interpreted “Series” to mean “a group of usuallythree or more things or events standing orsucceeding in order and having a like relationshipto each other: a spatial or temporal succession ofpersons or things”

• Court found environmental losses could not beaggregated because the acts of pollution occurredover 100 years and were disbursed geographicallyfrom “New Jersey to Oregon”

• Found that a “series” of accidents could be properlyaggregated if they “have a spatial or temporalrelationship to one another and a common origin”

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“Arising out of One Accident” inContext of Aggregation

Hartford Accident and Indemnity Co. v. Ace American Reinsurance Co.(Conn. Super. Dec. 2005), reversed, (Conn. Dec. 2007)

• Contract provided Reinsurers would be liable for losses, above aparticular threshold and below a specified limit incurred by thecedent under its policies “by reason of any one accident”

• Definition of “any one accident” included a “common cause”provision which provided for the aggregation of multiple lossesarising out of products “manufactured, made, handled, distributed orsold” by the insured as “any one accident” to the extent such lossesarose from a common cause

• Lower court declined to permit aggregation of 17,500 asbestosclaims under “common cause” language

• Connecticut Supreme Court reversed the lower court noting thatclause was uniquely broad and had never been construed by another court.

• However, “common cause” language was ambiguous as to whetherit allowed aggregation of losses that arose out of same pattern ofevents or contained spatial and temporal limitations that precludedthe aggregation of claims incurred at hundreds of different locationsover decades

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Aggregation Issues ArisingOut of Japan Disaster (U.S. Law)

Expect similar issues to those facing reinsuranceindustry in UK

Issues:

• Will earthquake, tsunami, fires and ensuing aftershocksbe considered “a series of accidents” constituting oneloss?

• Will the earthquake that initially struck Japan beconsidered the “common cause” of all other lossesassociated with the disaster to allow such losses to beaggregated as one accident?

• Will courts construe the language of the applicablepolicy defining “occurrence” or “Event” as ambiguous,thereby preventing a ruling on whether aggregationprinciples can be applied in the first place?

Contact Us:

Darlene K. AltPartner

Providence, RI401.276.6476

DAlt@eapdlaw.com

James T. KilleleaAssociate

New York, NY212.912.2908

JKillelea@eapdlaw.com

Nathan HullAssociateLondon

+44 (0) 20 7556 4666NHull@eapdlaw.com