Coverage for Supply Chain Disruptions

Supply Chain Insurance—When Is It Needed?

Supply chains are relationships between a seller or manufacturer of goods and the suppliers of materials the manufacturer incorporates into its product; for example, raw materials and component parts. Supply chains can suffer disruptions for numerous reasons, including weather and climate-related risks, price changes, transportation and storage failures and shortages in modes of transportation, labor shortages or disputes, political instability, financial or management issues affecting a supplier or vendor, physical losses to plants and storage facilities, or cyberattacks—all of which pose a significant risk to businesses. A disruption in one part of the supply chain can cause losses in other parts. This article examines the types of insurance coverage that make up “supply chain coverage” and common exclusions and pitfalls.

Contingent Business Interruption Insurance May Help

In general, commercial property insurance covers an insured’s business income losses only when those losses result from physical loss or damage to its own property. This coverage, without more, may not protect the business from disruptions in its supply chain. Often policies include “contingent” business interruption (CBI) coverage, which may cover losses due to supply chain disruptions. However, this coverage requires physical loss or damage, and coverage may be limited for certain suppliers listed on a schedule. See the following sample provisions:

This policy is extended to cover the actual loss sustained by the Insured due to the necessary interruption of business as the result of direct physical loss or damage of the type insured against to properties not operated by the Insured which wholly or partially prevents any direct supplier of goods and/or services to the Insured from rendering their goods and/or services, or property that wholly or partially prevents any direct receiver of goods and/or services from the Insured from accepting the Insured’s goods and/or services. ISO Form CP 00 30 10 91 (1990).

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Contingent Time Element. This Policy covers the Actual Loss Sustained and Extra Expense incurred by the Insured at an Insured Location during the PERIOD OF LIABILITY directly resulting from physical loss or damage of the type insured to property of the type insured at Contingent Time Element Locations located within the Coverage Territory: ISO Form PF-28906 (04/19).

CBI coverage is sometimes called “dependent properties” coverage. These provisions cover enumerated dependent properties, such as “those who supply materials for the insured, purchase the insured’s goods, or attract customers to the insured’s business.” “Regular business-interruption insurance replaces profits lost as a result of physical damage to the insured’s plant or other equipment; contingent business-interruption coverage goes further, protecting the insured against the consequences of suppliers’ problems.” Broadly speaking, CBI coverage “gives the insured coverage for loss of sales or revenue sustained when its business is interrupted as a result of damage to property that disrupts the flow of goods and services with a supplier or customer.”

CBI is triggered by loss arising from property damage to a dependent property. For instance, in Philadelphia Parking Authority v. Federal Insurance Co., the policyholder operated parking garages at Philadelphia International Airport and sought coverage for lost income following 9/11. After the attacks, the Federal Aviation Administration prohibited takeoffs and landings at airports in the United States, causing the policyholder to lose business at its dependent airport locations. The insurance company denied coverage under the CBI provisions because there was no “direct physical loss or damage” “to the insured premises.” The court agreed, concluding that “‘direct physical loss or damage,’ . . . requires that claimed loss or damage [to the dependent property] must be physical in nature.”

Other limitations on CBI coverage. CBI coverage has many important limitations. It usually is subject to a sublimit dramatically smaller than the business income limit. It protects a business only if its suppliers have suffered physical damage caused by a covered peril. In some cases, policies exclude physical damage arising from certain types of events, such as power outages. In addition, CBI coverage may apply only to the policyholder’s direct suppliers or customers (or both), even though modern supply chains may be much more intricate. CBI coverage also may require that the policyholder identify the specific property of its suppliers, partners, manufacturers, or customers that should be covered. It frequently does not cover losses caused by political disruptions, labor or production issues, road closures, or bankruptcy of a partner or supplier. However, coverage for some of these events may be available in certain circumstances.

Specialized Broad Supply Chain Insurance May Cover Disruptions

Specialized broad supply chain insurance provides broader coverage than CBI for supply chain disruptions. There are supply chain insurance policies—or named-peril policies called trade disruption insurance (TDI), specialized named-peril policies that generally cover loss of net profits caused by either physical perils or political perils due to foreign government actions or inaction that result in delayed production and loss of sales, and costs such as transportation, contingency measures, and customer or public relations and may include extensions for contractual penalties, liquidated damages, and financing costs. Such policies may help reimburse businesses for lost profits and costs caused by supply chain disruptions. Supply chain insurance is usually all-risk. There is no “standard” supply chain insurance form, but generally, it is easily customizable.

Although older supply chain policies may require physical damage, today’s supply chain insurance typically does not require physical damage. In addition to covering disruptions caused by property damage to suppliers or customers, supply chain insurance may, depending on the specific policy terms, cover partial or complete losses from potential risks among the following: natural disasters, industrial accidents, production issues, strikes, labor shortages, employment and labor issues, political upheaval, war and civil strife, civil unrest, disruption to the transportation infrastructure, industrial accidents, production issues, riots, political instability, public health emergencies, civil or military action, insolvency or bankruptcy, regulatory actions, and other events.

Cases addressing specialized supply chain coverage. Because supply chain coverage varies among insurance policies, some coverages require physical damage. Consequently, supply chain coverage cases fall into two categories: (1) supply chain coverage that does not require physical loss or damage to the supplier or customer and (2) supply chain coverage that does require such physical loss or damage. Older policies or policies based on older manuscript forms are more likely to contain this requirement.

In Crimcheck Holdings, LLC v. TNFC, Inc., the Actual Net Loss Insurance Policy provided that Crimcheck would be reimbursed for the “‘Actual Net Loss’ attributable to certain occurrences referred to as ‘scheduled events,’ because they were listed on the policy’s schedule of coverage.” Scheduled Event No. 66 defined a “Suppliers/Supply/Chain Interruption” event as follows:

the interruption or cessation of Insured’s business for a period of no less than 24 hours, as a result of the interruptions to the business of any supplier or customer of Insured, caused by interruptions not arising from damage to such supplier or customer’s property, including strikes, riots, issues with ingress/egress to Insured’s premises where there is no alternative route, pandemics, technology outages, or software failures; provided that such interruption or cessation of Insured’s business would not be covered under Scheduled Events: Business Interruption—Civil Authority/Emergency Response Risk or Business Interruption—Military Authority, whether Insured opted for coverage for such Scheduled Events or not. Actual Net Loss in connection with a Suppliers/Supply Chain Interruption event shall include Income Loss and Extra Expenses, including costs of cover, costs of advertising and marketing for new suppliers or customers, travel, lodging, meal and entertainment expenses incurred in selection of a new supplier or customer, and miscellaneous extra costs incurred in finding, meeting and negotiating with a new supplier or customer including costs to verify the background and references of prospective new suppliers or customers, and overtime pay and legal expenses incurred to draw up supplier or customer contracts.

The court found that Scheduled Event No. 66, therefore, “expressly covers losses due to ‘interruptions not arising from damage to [the relevant] supplier or customer’s property.’” The court noted that “while a state courthouse may not be what immediately comes to mind when one imagines a business’s ‘supplier,’ it is difficult to see how the appellation would not apply to courts, in the context of Crimcheck’s business model. Crimcheck sells information about criminal cases, which the courts at issue supply.”

The Tennessee district court held that Crimcheck was entitled to coverage because the scheduled event applied to business interruptions of the supplier “not arising from damage to such supplier or customer’s property.” Here, there was no damage to the courts, Crimcheck’s “supplier.” The courts simply did not have criminal records to supply to Crimcheck due to the pandemic. TNFC argued that it properly denied the claim because Crimcheck failed to state that its interruption or cessation lasted longer than 24 hours. The court noted that just because

Crimcheck continued some level of functioning during portions of the pandemic[] does not necessarily mean that it was continuously in operation. Any loss-creating cessation or interruption of Crimcheck’s business caused by the courthouses’ closure and lasting for at least 24 hours would have been sufficient to trigger the coverage, even if that brief closure had been surrounded on both sides by periods of reduced, but active, functioning.

The court held that, at the motion to dismiss stage, “it suffices to conclude that the Complaint alleges, albeit not as clearly as it could have, that a qualifying interruption of Crimcheck’s business occurred.”

In cases in which the supply chain coverage grant includes language requiring physical loss or damage to the supplier, however, courts enforce those provisions. For example, the Central District of California addressed supply chain coverage with a physical damage requirement as part of an all-risks property policy in J-M Manufacturing Co. v. Affiliated FM Insurance Co. “JM Eagle is the world’s largest manufacturer of high-grade, high-performance plastic pipes. [] Among other products, JM Eagle manufactures polyethylene (“PE”) and polyvinyl chloride (“PVC”) pipes at various production facilities.” Hurricane Harvey damaged J-M’s facility; seven of its resin suppliers suffered physical damage or impacts from Hurricane Harvey; and the resin suppliers were unable to supply adequate amounts of resin for three months to some of JM Eagle’s manufacturing plants, which JM Eagle alleged resulted in nearly $18 million in losses.

JM Eagle’s all-risks property policy provided supply chain coverage, which required physical loss or damage to the supplier’s property to trigger coverage:

This Policy covers the Business Interruption Coverage loss incurred by the Insured during the Period of Liability directly resulting from physical loss or damage of the type insured to property of the type insured at the premises of any of the following within the Policy’s Territory:

a) Direct suppliers, direct customers or direct contract service providers to the Insured;

b) Any company under any royalty, licensing fee or commission agreement with the Insured; or

c) Any company that is a direct or indirect supplier, customer or contract service provider of those described in a above,

. . .

Business Interruption Coverage loss recoverable under this Business Interruption Coverage Extension is extended to include the following Business Interruption Coverage Extensions.

. . .

f) Supply Chain.

The court found that the insurer was entitled to summary judgment because JM could not demonstrate physical loss or damage to the supplier locations. At least two suppliers stated they had suffered no physical loss or damage; evidence from another was that Hurricane Harvey did not have an impact on its resin shipments, and a fourth increased its resin shipments to JM.

The U.S. District Court for the District of Maryland considered an all-risk policy that included supply chain coverage as a business interruption coverage extension in Cordish Cos. v. Affiliated FM Insurance Co. The coverage in Cordish also required that the “loss . . . directly result[] from physical loss or damage . . . to property,” including to the policyholder’s direct or indirect suppliers and customers of contract service providers, including an extension for orders of civil authority. The court held that Cordish had not plausibly alleged direct physical loss or damage caused by COVID-19, foreclosing coverage.LP.

Tips to Address Typical Exclusions and Common Pitfalls

1. Physical loss or damage requirement. Examine the policy to ensure that physical loss or damage is not required. If physical damage is required, find its definition in the policy, by statute or state law.
   
2. Specifically named suppliers, customers, companies, or locations. Check requirements regarding named suppliers, customers, companies, or locations. Some policies require the supplier, company, or country to be specifically named in the policy on a schedule, leaving companies exposed if an interruption occurs with an unnamed critical supplier or customer or involving a country not specifically named.
3. Specifically named products or services. Check if the policy requires the products or services to be specifically named on a schedule. Some policies have such a requirement, leaving companies exposed if an interruption occurs relating to a different product or service.
4. Waiting period. Some policies require the insured to wait a certain time before its losses are covered.
5. Duration of coverage. As with standard business interruption coverage, there may be a time limit on the duration of coverage.
6. Sublimits. Particularly when provided as part of a broader property policy, coverages for CBI or supply chain disruptions may be significantly smaller than the overall policy limit.
7. Geographic limitations. Some insurers may limit coverage to when there has been a loss to a supplier located only in the United States or within the same state as the insured’s business.
8. Causation issues. The insured must prove its financial loss and that it was caused by third-party disruption. This may be challenging in complex supply chains.
9. Loss of power or other utilities exclusions. Supply chain coverage typically excludes loss of power or other utilities. An insured generally must purchase service interruption coverage by endorsement. Example endorsement:
   
   This policy . . . also insures against loss resulting directly from necessary interruption of business caused by damage to or destruction, by the perils insured against, of electrical transmission lines and other electrical equipment and steam and gas transmission lines situated in the open outside the described premises but within 1,000 feet thereof, when used exclusively for the service of the insured.
10. Physical damage requirement. Some policies may require physical damage to the product or material itself.
11. Surplus line. Supply chain coverage may be from a surplus line, so the insurer’s duties and obligations under state law may differ from those governing admitted insurers. Should a coverage dispute require litigation, most states require surplus line insurers to post a bond with the clerk of court in an amount sufficient to cover any judgment entered against it.
12. Policyholders should evaluate and monetize their losses.
13. Policyholders must abide by coverage conditions, like timely reporting, following the claim submittal process (reporting the loss in the way specified in the policy using the proper forms and providing the requested materials), cooperating with the insurer, minimizing losses where appropriate, and other conditions.
14. Information-flow issues often exist because the interruption occurs outside the insured’s control. Namely, third parties often have information necessary to resolve coverage. Suppliers may posture to avoid liability to the insured and not want to play ball at all or want some assurances in return.
15. Other coverages may help fill some gaps in supply chain or CBI coverage:
    1. Political risk insurance is a specialized first-party insurance that covers the risks to assets and investments in politically risky parts of the world. It may expressly insure against specified political perils such as nationalization of property, confiscation of assets, significant regulatory changes, war, and terrorism.
    2. Marine insurance covers the transportation of goods over the ocean or by land and frequently covers specified losses such as collisions or ships becoming stranded or unseaworthy. Marine insurance may provide some coverage for equipment, merchandise, or goods in transit or storage that may not reach their destinations on time or at all. However, coverage is triggered by the cause of the delay and, for that reason, provides only indirect supply chain disruption coverage.
    3. Cyber insurance may provide some third-party coverage to businesses further down the supply chain if a cyberattack affects a supply chain. Coverage issues may arise if the cyber policy does not specify that money damages are payable for losses sustained as a result of a supply chain disruption, and exclusions may apply.
    4. Trade credit insurance protects policyholders against risks associated with extending credit to customers. These policies generally exist in three forms: default coverage for export sales, default coverage for domestic sales, and insolvency risk coverage for domestic sales. Trade credit insurance can be structured to provide coverage for a single buyer or multiple buyers.
    5. Civil authority coverage and ingress/egress coverage, generally included in first-party property policies, cover business interruption losses and, in some cases, necessary extra expenses due to actions of local, state, or federal authorities, including evacuation orders or curfews and highway closures that prohibit access to the policyholder’s or supplier’s premises. Property damage is not a prerequisite for ingress/egress coverage under the ISO form.
    6. Port blockage coverage may provide time element coverage for businesses dependent on access to navigable waters for loss resulting from (1) vessels being denied access to or egress from an insured facility or another property or (2) the inability to deliver cargo from a vessel that does reach the facility.

Conclusion

In sum, in an increasingly global and interconnected economy characterized by complex supply chains, supply chain coverage can offer companies a source of resilience. Yet, due to its nature and the complexity of insureds’ operations, obtaining effective supply chain insurance (and availing oneself of coverage following a loss) can be rife with potential pitfalls.