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Hindsight Vs. Foresight: The Adjustment Of Business Income Claims

May 1, 2007

A Debate Renewed

This article was originally published in For The Defense, May 2007, Vol. 49, No. 5.  Reprinted by permission.

The hurricanes of 2004 and 2005 resulted in many claims for loss of business income. Applying this coverage, which is always tricky, can be even more problematic in the context of widespread devastation.  

Business Income Loss Claim Variables

There are two significant variables in the adjustment of a business income loss claim. The first is the time element or “period of restoration,” which is the time necessary with the exercise of due diligence and dispatch to repair or replace the damaged or destroyed property to its condition immediately before the loss. The second is the probable amount of business income lost during that period, had no loss occurred and as a direct result of the covered loss. Depending upon the policy language, this is expressed as either gross earnings less non-continuing expenses, or net profit (or loss) plus continuing expenses.

Regarding the first variable, the period of restoration in the garden-variety claim for loss of business income, the insured first does what is necessary to get back into business – “resume operations,” as it is called in many policies. Often, the period of restoration has begun and ended before the insured puts together the material to make the claim. In those sorts of claims, it is easy to view the loss in hindsight and, with certainty about the first variable, calculate the indemnity due.

This article, however, addresses the difficulty that arises when the period of restoration is ongoing, but the insured does not resume operations due to the sale of the insured property. Faced with the monumental task of rebuilding after a catastrophe, some business owners simply elected to throw in the towel, sell the business for whatever it might bring, and move on. Many times this happened during what would ordinarily have been the period of restoration.

Let us take a specific example. A hotel has substantial damage from Hurricane Wilma. The insured and insurer agree that the period of restoration will be eight months. Four months into the period of restoration, the owners of the hotel sell it. The insured/seller either retains the right to the loss of business income claim or assigns that right to the buyer. This article will address both possibilities.

The insured/seller or the buyer/assignee contends that the insurer owes for a full eight months of loss, notwithstanding the transfer of ownership, because the claim should be adjusted as of the date of the loss. In other words, the insurer must view the claim prospectively, with foresight as of the date of the loss. The insurer contends that the insured/seller’s interest in the property, and corresponding loss of business income claim, ended on the date of sale. In other words, the claim can only be viewed retrospectively, in hindsight.

So, should the loss be adjusted as of the date of loss based on the anticipated period of restoration and assuming continued ownership, or must the loss be adjusted after the period of restoration is over based on what actually occurred? It was the authors of Business Interruption Insurance—Its Theory and Practice (The National Underwriter Company 1987), Robert M. Morrison and Alan G. Miller, who, in debating this question in a broader context, first characterized it as “foresight vs. hindsight.” In their book, Morrison and Miller referenced various cases and weighed the theories that support each side of the question. Ultimately, they concluded there was no good answer. Indeed, regardless of the answer, the insured might either receive a windfall or be paid less than the terms of the policy would seem to require.

The determination of whether to apply hindsight or foresight in the adjustment of any particular claim for loss of business income must begin with the policy language. There are many forms in use with subtle differences that may dictate different results. The Insurance Services Office (“ISO”), for example, publishes a typical business income coverage form that provides, in pertinent part:

We will pay for the actual loss of Business Income you sustain due to the necessary “suspension” of your operations during the “period of restoration.” The “suspension” must be caused by direct physical loss of or damage to property at premises which are described in the Declarations and for which a Business Income Limit of Insurance is shown in the Declarations. The loss or damage must be caused by or result from a covered Cause of Loss.

* * *

3. Loss Determination

a. The amount of Business Income loss will be determined based on:

  1. The Net Income of the business before the direct physical loss or damage occurred.
  2. The likely Net Income of the business if no physical loss or damage had occurred, but not including any Net Income that would likely have been earned as a result of an increase in the volume of business due to favorable business conditions caused by the impact of the Covered Cause of Loss on customers or on other businesses;
* * *

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Part of the ISO language appears to support the application of hindsight in the adjustment of a business income claim. The policy says the insured will be compensated for the “actual loss” sustained, and this language appears in many, many business income policies. Arguably, “actual loss” cannot be determined until after the period of restoration has expired and the duration, amount and extent of business income loss are made manifest. Any payment based on anticipated business income would be merely an estimate, not the “actual loss sustained.”

The Principle of Indemnity

Moreover, hindsight is consistent with the principle of indemnity. The principle of indemnity is to compensate the insured for its damage or loss, but not to provide a windfall or enrichment. If the hypothetical calculation based upon foresight in the adjustment of a loss of business income claim yields a loss amount that the insured has not actually sustained, or is not reasonably expected to sustain, then such payment would not be indemnification. Thus, the application of foresight can sometimes violate this principle that underlies all property insurance.

Of course, there can be instances when the parties choose to contract around the principle of indemnity. For example, if a policy is based on replacement cost, the insured may receive a payment for the cost of full replacement of the damaged properties before doing any repairs or replacing anything. This violates the principle of indemnity because a payment for the actual cash value of the damage would fully indemnify the insured for the full extent of its loss until repair or replacement takes place.

Turning back to the ISO language quoted above, we find language that appears to support the application of foresight, as well. Under that provision, consideration must be given to the condition of the business before the loss or damage occurred. The loss of business income will be based upon “the likely Net Income of the business . . . ,” starting with the condition of the business before the loss and projecting the loss without regard to subsequent events — such as the sale of the business. This appears to conflict with the notion of “actual loss sustained,” but the rules of interpretation dictate that every word in the policy be given meaning, including the word “likely.” Thus, it could be argued that the policy contemplates using the prior business experience and extrapolating this over the period of restoration.

Sale without Restoration

As indicated above, in the wake of the hurricanes, the problem of foresight versus hindsight often was presented when the insured decided to sell the business without restoration. Practically speaking, the insured had no loss of business income after the date of the sale. The sale of the business cut off any expectation or likelihood of further income. On the other hand, the insured did suffer a loss and the policy pays for business income during the period of restoration. There are competing cases.

B A Properties, Inc. v. Aetna Cas. & Sur. Co., 221 F. Supp. 2d 592 (D. V.I. 2002) (“B A Properties I”) is a recent case dealing with the sale of a business and its impact on a business interruption claim. A different judge eventually vacated this decision and its rationale. But, the analysis of B A Properties I is important because it was relied upon by a New York court in a subsequent decision, also discussed below.

In July 1994, Bank of America Corporation foreclosed its mortgage on a luxury resort in St. Thomas, Virgin Islands, then known as the Grand Palazzo Hotel. An affiliated entity, B A Properties, took possession of the hotel. On March 31, 1995, Aetna, Zurich and United States Fire issued policies of insurance to Bank of America insuring the property. On September 15, 1995, Hurricane Marilyn hit St. Thomas, causing damage to the hotel.

In March 1996, B A Properties submitted a claim for losses in excess of $30,000,000, which included both property damage and business interruption. On or about June 13, 1996, B A Properties sold the hotel to Marriott, which repaired the property and renamed it “Frenchman’s Reef.” The insurers accepted the claim, but refused to pay any business interruption losses after the date of the sale, arguing that the insured did not have an insurable interest after that date. B A Properties filed suit for breach of contract, contending that it was entitled to business interruption losses for the entire amount of time it would have taken B A Properties to rebuild the hotel if it had not sold it. The insurance policy in B A Properties I provided:

If such loss occurs during the term of this policy, it shall be adjusted on the basis of actual loss sustained by the Insured, including ordinary payroll, consisting of net profit which is thereby prevented from being earned, fees, penalties, and all charges and other expenses only to the extent that they continue during the interruption of the business, and only to the extent to which they would have been earned had no loss occurred.

B A Properties argued that the amount of the business interruption coverage owed by the insurers can be determined on the date of the loss and that the subsequent sale of the insured risk, the hotel, had no effect on that determination. B A Properties pointed to a policy provision that defined the outside limits of the first variable, the period of restoration or “suspension.”

(1) Determining Loss:

The length of time of suspension of business for which loss may be claimed:

(a) shall not exceed such length of time as would be required with the exercise of due diligence and dispatch to rebuild, repair, or replace such part of the property as has been destroyed or damaged including any additional time required to comply with laws and ordinances.

B A Properties argued this provision contemplated a “theoretical” period of restoration.

The district court rejected this argument and held that plain language elsewhere in the policy controlled the analysis. The court stated:

The policy provides coverage only for the actual losses sustained by the insured while the Hotel’s business was interrupted due to the hurricane: “If [a business interruption] loss occurs during the term of this policy, it shall be adjusted on the basis of ACTUAL LOSS SUSTAINED . . . only to the extent that [the losses] continue during the interruption of business . . . .” The policy specifically contemplates that things may happen during the reasonably predictable period of business interruption that will affect the calculation of the loss the insured actually sustained. The amount of the actual loss sustained thus was not fixed at the time of the hurricane; it was subject to adjustment during the reasonably projected period that the Hotel would be out of business due to the storm damage. . . . Accordingly, I find that B A Properties’ sale of the Hotel to a third party reduced to zero the amount of continuing business losses it experienced as a result of the hurricane. . . . Following the sale of the property, B A Properties no longer had any recognizable right to a stream of income from the Hotel and could no longer show the actual losses sustained required under the business interruption coverage of the Master Policy.

(emphasis in original)

Subsequent activity in this case muddied the water. After the decision in B A Properties I, the district judge recused himself. The successor judge vacated the ruling above and issued a contrary order in B A Properties v. Aetna Casualty & Surety Company, 273 F. Supp 2d 673 (D.V.I. 2003) (“B A Properties II”).

In B A Properties II, the district court relied on policy language which, when determining “actual loss,” must include “consideration given to the experience of the business before the date of damage or destruction and to the probable experience thereafter had no loss occurred” and relied on the notion that “actual loss sustained” was not synonymous with “actual loss experienced.”

The term “actual loss sustained” does not mean that an actual loss must be experienced. Georgia-Pacific Corp. v. Allianz Ins. Co., 977 F.2d 459, 463 (8th Cir.1992). “A profitable business … can prove it will fail to earn net profits because of the interruption based on the business’s actual experience before the accident and the probable experience it would have had without the accident.” Id. (quotation omitted). The Policy clearly states that the actual loss can be determined with “due consideration given to the experience of the business before the date of damage or destruction and to the probable experience thereafter had no loss occurred.” Policy, PTY-5, ¶ (3). Thus, the “actual loss sustained” limitation means only that an actual loss must be predictable from past business experience. The further restriction that only those expenses that continue during the business interruption are covered means that the Policy covers only expenses that the insured would have been able to pay had it continued in operation. See Hampton Foods, Inc. v. Aetna Cas. and Sur. Co., 787 F.2d 349, 354 (8th Cir. 1986). To construe this restriction as requiring that B A Properties continue to own the Hotel to be able to recover its continuing expenses would be to stretch it beyond its common meaning.

Thus, the B A Properties II court appears to suggest that post-loss financial results are irrelevant since the calculation should be based on the experience before, and probable experience after, the loss. However, the court did not end its analysis there. The B A Properties II court went on to use the theoretical period necessary to repair the property in an effort to arrive at a calculation of the “actual loss sustained.”

Under the terms of the Policy, business interruption losses are calculated based on a period which “shall not exceed such length of time as would be required with the exercise of due diligence and dispatch to rebuild, repair, or replace such part of the property as has been destroyed or damaged including any additional time required to comply with laws and ordinances.” Forsberg Decl., Ex. A, PTY 4, ¶1(a). This period is standard; it “runs concurrently with an interruption due to an insured peril and lasts until the damaged property is restored.” See Pennbarr Corp. v. Insurance Co. of North America, 976 F.2d 145, 154 (3d Cir. 1992).

The Policy does not require the insured to rebuild or to resume business operations to be compensated for its business interruption losses. Nor is there a provision shortening the length of time for which the insured can recover for the interruption of its business in the event that the insurable interest is conveyed to a third party. If the insurers intended to provide B A Properties with “a business interruption policy with an indemnity period distinct from that of a ‘standard’ business interruption policy, the final product should have included clear language evincing as much.” See id.

Finally, to limit B A Properties’ indemnity period to the date of sale of the Hotel would shortchange B A Properties, if the Hotel could not have been restored by that date. “[T]he purpose of business interruption insurance [is] to return to the insured that amount of profit that would have been earned during the period of interruption had a casualty not occurred.” Id. If B A Properties’ recovery is reduced because it sold the Hotel during the period of interruption, it would defeat the very purpose for which B A Properties purchased business interruption insurance. An interpretation of the . . . Policy that would negate its primary purpose is not preferred. See Restatement (Second) of Contracts §203.

Setting aside semantic differences between “sustained” and “experienced,” the B A Properties II decision fails to address two important points. First, it does not tackle the violation of the principle of indemnity and the resulting windfall to the insured. Second, despite considerable focus on the existence of an insurable interest at the time of the damage, the court seemingly ignores the fact that, unlike its interest in the cost to repair the physical damage, the insurable interest of B A Properties in its insured but prospective income loss was subsequently extinguished by the sale of the damaged property.

When a policy is one of indemnity, an insurable interest must exist at the time the loss is sustained. Couch on Insurance 3d, §41:15. Since business interruption is a time element coverage, that is, it continues over the period of restoration, it stands to reason that the loss is on going during that period, and the insured must have an insurable interest for the duration. Sale of the property during that period extinguishes the insurable interest.

An older case that decided this issue was Holt v. Fidelity Phoenix Fire Insurance, 273 A.D. 166, 76 N.Y.S.2d 398 (N.Y. App. Div. 1948). In Holt, the insured sued to recover under a business interruption policy issued to a movie theater. The policy provided that, if the building were damaged by fire, the coverage would pay for losses the owner sustained during the period necessary to repair the premises. On March 1, 1946, a fire damaged the property and suspended operations. On March 11, 1946, the insured sold the property and assigned the entire claim to the new owner. The new owner brought suit to recover the business interruption loss that occurred beyond the date of the sale. The court rejected the new owner’s contentions and concluded that the plaintiff did not have an action for the damages after the sale date of the property. The Holt court concluded that, upon the sale of the theater, the insured’s business no longer existed and one could not collect for “lost” income of a business that no longer existed.

In the time between the publication of B A Properties I and B A Properties II, the issue was addressed in Bronx Entertainment, LLC v. St. Paul’s Mercury Insurance, 265 F.Supp.2d 359 (S.D.N.Y. 2003). In that case, the plaintiff was the buyer of a “golf center,” including a driving range, miniature golf course and batting cages. As part of the sale, the insured/seller assigned to the plaintiff its right to a loss of business income claim due to wind damage to the netting over the driving range. St. Paul denied that part of the claim for the business interruption extending beyond the date of the sale, because the plaintiff/buyer had not sustained any business loss.

In a summary disposition of the issue, the district court held that business interruption losses terminated upon the sale of the property. Once the insured/seller sold the property, there was no further income loss due to the wind damage. The court cited and relied upon both B A Properties I and Holt.

Likewise, [as in Holt] in the instant case, plaintiff is seeking to collect business interruption damages arising out of a business which did not come into existence until 17 days after the wind damage, and after Family Golf, the named insured, to whom defendant had issued its policy had ceased to operate the business covered and had transferred the title, ownership and control of the premises to plaintiff. Therefore, plaintiff cannot assert a claim for losses it suffered. Of course, plaintiff may maintain an action for Family Golf’s losses that accrued as of the date of the assignment. However, plaintiff is proceeding on the theory that it is also entitled to those business losses which had yet to occur at the time of the assignment. This plaintiff cannot do because it would, in effect amount to an assignment of the entire policy to which defendant did not consent. Therefore plaintiff’s second cause of action, to the extent that it alleges losses it suffered after the assignment, must be dismissed.

Responding to the contention that St. Paul had received a windfall as a result of the decision, the district court opined:

It may appear that St. Paul is getting a windfall as a result of the sale of the business because if Family Golf had continued as the owner, it would have been entitled to be compensated by St. Paul for its business interruption losses during any additional period required for restoration of the netting. However, plaintiff bought the Golf Center with full knowledge that the golf range was out of operation until the netting could be restored and this was undoubtedly taken into account in negotiating the purchase price. Thus St. Paul’s benefit presumably comes at the expense of Family Golf and not of plaintiff and allowing plaintiff to recover on its business interruption claim would give the windfall to it instead.

Thus, Bronx Entertainment makes it clear that a buyer, especially one that, as in that case, does not even exist at the time of the loss, has no claim for lost business income after the sale, even if based upon an assignment of policy proceeds.

The foregoing analysis of Holt and Bronx Entertainment was confirmed in a recent case involving the sale of a business following the World Trade Center disaster of September 11, 2001 and claim for business interruption losses. The court in Globecon Group, LLC v. Hartford Ins. Co., 434 F.3d 165 (2d Cir. 2006), cited to the Holt and Bronx Entertainment decisions when it affirmed summary judgment for the insurer regarding business losses incurred after the sale of the business. In doing so, the court reasoned that an interruption of the insured’s business was measured by “its business experience before the loss and of its probable experience thereafter.” Looking to Bronx Entertainment, the Globecon court stated that an “assignee ‘may maintain an action for [the original insured’s] losses that accrued as of the date of the assignment’ but was not ‘entitled to those business losses which had yet to occur at the time of the assignment.'” The court distinguished these losses, however, from those claimed by the named insured prior to the sale, and assigned to the purchaser of the business. Where the insured had made a valid claim to its insurer for business interruption losses prior to the sale, and had assigned the right to those claimed losses under the asset purchase agreement, any proceeds under such a claim would be validly transferred to the purchaser under that agreement.

The Globecon court referenced the distinction made in SR International Business Insurance Co., Ltd. v. World Trade Center Properties, LLC, 375 F.Supp.2d 238 (S.D.N.Y. 2005). Although the SR International case dealt with rental value coverage, the parties disputed, and the court examined, whether the rental value claim was assignable or whether the Holt and Bronx Entertainment cases precluded the assignment. The holding in the SR International case establishes the logic that losses which accrue at the time of the insurable event are assignable while losses that accrue after the insurable event and after the time of sale are not assignable. The court reasoned that a loss which accrues at the time of the insurable event is fixed at that time while a loss which accrues after the time of the insurable event is speculative. The SR International court indicated that, based on this rationale, business interruption losses are speculative while rental value losses are fixed. Thus, the Globecon and SR International cases appear to create a rebuttable presumption that business interruption losses after the sale date (speculative) are not assignable while rental value losses (fixed) are assignable. However, one concept that the Globecon and SR International courts did not consider in their decisions is the notion that the principle of indemnity limits one’s recovery to the extent of one’s insurable interest.

All of the foregoing decisions dealt with a claim by an assignee or other successor to the interest of the original insured. Less clear is the validity of an insured’s own claim for post-sale proceeds. Returning to policy wording, ISO appears to have recognized this potential problem. Some recent forms contain a provision in the business income coverage form that attempts to address this issue. This provision is:

d. If you do not resume “operations”, or do not resume “operations” as quickly as possible, we will pay based on the length of time it would have taken to resume “operations” as quickly as possible.

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This language clearly provides that a business income claim will be adjusted with foresight if the insured does not resume operations. This, of course, violates the principle of indemnity.

Why then should the result be different, depending upon whether the insured sold the damaged property or retained, but did not repair it? While a result finding continued coverage after a sale can be justified as another example where the insurer has contracted around the principle of indemnity or the rebuttable presumptions of SR International and Globecon have been overcome, the better answer, the authors submit, is found in the presence or absence of an insurable interest.

In the 20 years since Morrison and Miller debated these concepts, there have been only a few cases on point. As illustrated, they give no final answer, but they do illustrate both sides of the debate. In instances where the property has been sold during the period of restoration, however, the answers seem clear: The absence of an insurable interest eliminates any further claim after the date of the sale of the damaged property, both as to the purchaser as well as to the insured/seller.

The necessity of a claimant to have an insurable interest in the property insured is now a universal truth, whether by statute or case law, and the absence of an insurance interest renders the policy void and unenforceable as a wagering contract. Couch on Insurance, 3d, §41:1. Florida’s definition of insurable interest is typical:

any actual, lawful, and substantial economic interest in the safety or preservation of the subject of the insurance free from loss, destruction, or pecuniary damage or impairment.

Fla. Stat. §627.405(2)

While some states hold an insurable interest need only exist at the time the contract is entered into, the principle of indemnity supports the better view that such an interest must be present at the time of the loss. Again, using Florida as an example:

No contract of insurance of property or of any interest in property or arising from property shall be enforceable as to the insurance except for the benefit of persons having an insurable interest in the things insured as at the time of the loss.

Fla. Stat. §627.405(1)

An insurable interest in the cost to repair the physical damage is fixed as of the date of the loss. This, however, is fundamentally different from a business interruption loss, which represents income to be realized over the period of restoration. It stands to reason an insurable interest must exist over that period as well. The case law, albeit limited, supports the conclusion the purchaser has no claim, even if by assignment of policy proceeds. As the court in SR International indicated, the business interruption loss is usually speculative and cannot be quantified at the time of the insurable event. If the assignee cannot quantify the assignor’s claim, it stands to reason the assignor suffers the same disability.

As noted, however, both SR International and Globecon hold out the prospect a claimant might be able to eliminate the uncertainties rendering a claim for business interruption speculative (as in Globecon) or a defending insurer might be able to create sufficient uncertainty to render a claim for rental value speculative (as in SR International). Before entertaining such evidence, however, the presence or absence of an insurable interest must be considered, a concept which, the authors submit, should end the inquiries.

As yet another hurricane season approaches, additional opportunities to resolve this issue, with finality, will present themselves.