A Calculated Move

In general, business-interruption coverage insures against loss resulting from the necessary suspension of the insured's business caused by perils covered under the policy. Business-interruption coverage contains provisions setting forth the method of calculating business-interruption damages. A fairly standard phrase provides that "due consideration shall be given to the earnings of the business before the date of damage and the probable experience thereafter had no loss occurred."

Therefore, should business-interruption damages be calculated, at least in part, based on lost profits during the time the business was interrupted, using earnings as they existed after the catastrophe? Or should the calculation be based on earnings as if the catastrophe had not occurred at all? That is, should only pre-catastrophe earnings be taken into consideration?

Some courts have focused on the principle that a policyholder should be put in the same position it would have been in had the catastrophic event not occurred, and thus, these courts have held that the policyholder is not entitled to a windfall due to favorable economic conditions created by the peril. What is interesting about these cases is that they appear to bring a new interpretation to bear on an old familiar term. They interpret the term loss in the policy as being synonymous with the catastrophic event that caused the business-interruption loss, as opposed to the specific damage sustained by the insured.

Prudential LMI Commercial v. Colleton Enterprises, Inc., 976 F.2d 727 (4th Cir. 1992) (applying South Carolina law) is such an example. In that case, the insured owned an Econo Lodge motel in South Carolina that was damaged by Hurricane Hugo. The motel owner argued that it should recover profits it would have earned had the motel "been able to accommodate the influx of repair persons and construction workers in the Charleston area during the months after the hurricane." The insured's argument was that if the motel had not sustained a loss from the hurricane, it would have realized those profits. The district court agreed with the insured, but on appeal, the Fourth Circuit found that the district court misinterpreted the policy language that resulted in a windfall for the insured for which the court had not bargained.

The policy provision at issue in that case provided as follows: "Due consideration shall be given to: a. the earnings of the business before the date of damage or destruction and to the probable earnings thereafter, had no loss occurred …."

Prudential argued two positions for why it did not owe the insured for any lost profits. First, it argued that because the motel had recorded losses in excess of $350,000 during the 32-month period preceding Hugo, the insured sustained no business-interruption losses. Second, it argued that it did not owe the insured for any lost profits because the class of lost profits claimed, i.e., the probable earnings resulting from accommodating the demand due to the hurricane, was not covered under the policy. This second argument was based on the phrase, "had no loss occurred."

With respect to the first position, the Fourth Circuit found that Prudential's argument was too limiting. The court observed that even though the motel had operating losses for more than 32 months preceding the hurricane, it did not mean that the motel did not sustain business-interruption damages. The court stated that the policy language did not limit the policyholder to prove lost profits simply by reference to evidence of the pre-casualty experience. The court found that the policyholder could rely on evidence that, without regard to what he had been doing, and even if he had been doing badly, he nevertheless would have earned a profit during the period of interruption had it not occurred. For example, he might prove that a general economic upturn for the business had been imminent, or that a specific event had created a profit opportunity that the peril's occurrence had thwarted.

Thus, the court found that the insurer's attempt to limit the business-interruption loss to the earnings history preceding the loss was inappropriate, and that the calculation should take into consideration potential earnings during the period of interruption.

However, the court also found that the policyholder could not take advantage of any increase in earnings due to favorable economic effects of the hurricane. With respect to Prudential's second position, the Fourth Circuit framed the question as follows: "[W]hether … the lost opportunity to house the influx of temporary residents after the hurricane constitute[d] a loss of earnings cognizable under a policy that is designed to return the Econo Lodge to the position it would have occupied had the hurricane not occurred?" Thus, the court in Colleton equated the term loss with the catastrophic event.

The court had a conceptual problem with the policyholder's argument that, had the hurricane not damaged it, the motel would have been able to profit from the influx of temporary workers during the period of business interruption that followed the storm. The court observed that, "Had the hurricane not occurred (the policy's built-in premise for assessing profit expectancies during a business interruption), neither would the specifically claimed earnings source have come into being. To allow the claim, therefore, would be to confer a windfall upon the insured rather than merely put it in the earnings position it would have been in had the insured peril not occurred. Business-interruption insurance of the type in issue here is not intended to provide such windfall coverage."

The dissenting opinion in Colleton highlights the other side of the debate. The dissent pointed out that the majority framed the issue as what the motel's situation would have been had the hurricane not occurred. He found that was improper because the policy stated that due consideration be given to pre-damage earnings and "the probable earnings thereafter, had no loss occurred." He contended that the phrase, "had no loss occurred," did not refer to the overall loss in the surrounding area, but rather clearly referred only to the loss incurred by the insured. He further observed that although Hurricane Hugo caused both the property loss and created the profit opportunity, it did not strike him as problematic to permit recovery under those circumstances.

More Legal Decisions

Following the majority opinion in Colleton, the court in American Automobile Ins. Co. v. Fisherman's Paradise Boats, Inc. (S.D. Fla. Oct. 3, 1994), held that windfall profits were not within the scope of the policy at issue in that case. The issue there was "whether historic financial data or post-interruption profit expectancies should be used to calculate the business interruption insurance benefits."

The case arose out of Hurricane Andrew. Fisherman's was engaged in the retail and catalogue sales of boats and marine accessories, items that allegedly were in great demand following the hurricane. One of Fisherman's stores was damaged by wind from the hurricane and was closed for a period of time and its business interrupted.

The business-interruption coverage provided that the criteria for determining loss included "(1) The net income of this business before the direct physical loss or damage occurred; (2) the likely net income of the business if no loss or damage occurred."

Fisherman's contended that its lost profits should have been based on post-interruption profit expectancies, arguing that it was entitled to its "lost opportunity in the increased economic opportunities afforded after Hurricane Andrew." It offered a market survey of Dade County residents, which showed the amount of boats and marine accessories residents would have purchased from Fisherman's had it been operating after the hurricane.

The court, citing Colleton, explained that the "logical inconsistency is that had no hurricane occurred (the policy's built in premise for assessing profit expectancies during business interruption), [then] neither would the claimed earnings source." The court stated that the policy language allowed a net income projection that was not itself created by the peril, and thus windfall profits were not within the scope of the policy.

In contrast, the court in Levitz Furniture Corp. v. Houston Cas. Co. (E.D. La. Apr. 28, 1997) held that the policyholder was entitled to recover profits derived from increased consumer demand caused by the disaster itself. In Levitz, the policyholder's building sustained damage from flooding that destroyed its entire showroom inventory. The store closed for 67 days. Levitz claimed that it was entitled to recover lost profits based on an increased consumer demand that resulted from the flood. The insurer, citing Colleton, argued that the increased profit potential created by the flood was not recoverable. The court disagreed with the insurer and found that Levitz was entitled to recover the estimated increase in profits due to the anticipated increase in consumer demand. In reaching this decision, the court distinguished the policy language at issue in the Levitz policy from the language in the Colleton policy, and found that the Levitz policy language did not prohibit recovery for profits created by the favorable economic conditions caused by the flood.

A Matter of Interpretation

As these cases demonstrate, the issue should be determined by the policy language. However, as the majority and dissenting opinions in Colleton demonstrate, the language may be interpreted in different ways. These cases, none of which are published opinions, allow for legitimate arguments on both sides of the issue.

Presumably, claims arising under the current version of the standard business income coverage are less likely to be subject to this same dilemma. The current language provides that 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 any 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.

Commentators have suggested that pursuant to this language, there is no coverage for windfall profits that the policyholder would have been able to earn if only its own facility had not been damaged by the same event that brought about the favorable business conditions.

Although this language is not perfect, it does appear to exclude coverage for lost profits due to favorable business conditions created by a catastrophic event. Thus, the adjustment of business-interruption claims under policies with this or similar language should be more straightforward.

Jay W. Brown and Hilary C. Borow are both partners at the Texas-based law firm Beirne Maynard & Parsons L.L.P. They can be reached at 713-623-0887.