Rebounding From a Recall: Insurance Coverage That May Save the Day

March 2, 2010

The recall of certain Toyota vehicles has generated a huge media storm in recent months. With millions of people impacted in some fashion by the problems experienced by the popular automaker, naturally questions abound regarding who will pay for what for recall-related events. Questions have been raised not only about insurance coverage for Toyota owner's vehicles in case of an accident, but also about coverage for the company itself for product recall, D&O, and product liability claims. While we cannot know what coverage or financial provisions Toyota may have, we are using this opportunity to provide a brief overview of coverages that exists for such situations. This article was researched and written by Kelly Maheu, J.D., and Christine G. Barlow, CPCU.

 

In November of 2009, Toyota recalled 3.8 million vehicles to fix problems with sticky gas pedals and floor mats that can snag the gas pedal and cause unintended acceleration. Another 2.1 million vehicles were recalled in January 2010 for the same problem. Many of these recalled vehicles were newer model Camrys and Corollas; other recalls involve Priuses with braking problems and Corollas with steering problems. The total number of recalled vehicles is roughly 8.5 million. While this is a large number of vehicles and an event receiving significant media attention, it is not the largest vehicle recall to date.

 

In 2008, Ford recalled 12 million vehicles including Lincoln and Mercury SUVs, pickups, cars, and vans ranging from model year 1993 to 2004. The cruise control would catch fire, sometimes hours after the vehicle had been parked. In 1996 Ford recalled 8.6 million vehicles because of fires caused by faulty ignition systems, and this recall included Escorts, Mustangs, Tempos, Thunderbirds, Cougars, Crown Victorias, Grand Marquis, Town Cars, Aerostars, Broncos, and F-series trucks from years 1993 to 1998.

 

There are other recalls involving different manufacturers and various numbers of vehicles, but one of the most famous vehicle recalls was that of the Ford Pinto. In 1978, 1.5 million Pintos and 30,000 Mercury Bobcat sedans were recalled because of fuel tank design defects that made the vehicles susceptible to fire in the event of a rear end collision. Internal documents from Ford showed that the company was aware of the problem, but a cost benefit study showed it was cheaper to pay for burn deaths and injuries than to make modifications to the fuel tank to prevent such incidents. This knowledge by the company led a California jury to award $125 million dollars to a party who was injured when his Pinto was rear-ended and burst into flames. The jury's reasoning was that since Ford knew of the problem, punitive damages should be more than Ford had made in profit on the vehicle. The judge later reduced the award to $3.5 million, but it is easy to follow the jury's logic.

 

Currently Honda has recalled 952,118 vehicles because of airbags inflating with too much pressure and then injuring or killing the driver, and Volkswagen has recalled nearly 200,000 cars in Brazil because of a rear wheel problem that could cause the wheels to lock or in extreme cases loosen and fall off. In addition, General Motors Co. is recalling 1.3 million Chevrolet and Pontiac compact cars sold in the U.S., Canada and Mexico to fix power steering motors that can fail.

 

These recent recalls raise many questions surrounding possible insurance implications for consumers and companies alike. The following is a discussion of several of these relevant coverage-related issues.

 

Personal Auto

 

Many insureds are questioning how the recall will affect their personal auto coverage. If a driver's vehicle is among those included in the recall and he fails to bring it in for necessary repair, he should be covered by his collision or liability insurance if his vehicle is involved in an accident. Coverage should still apply even if it can be proven that the recalled part was the proximate cause of the accident and that the driver knew his vehicle was part of the recall.

 

Some will argue that given the highly publicized nature of the Toyota recall, owners are undeniably on notice that their vehicle is part of the recall. So, wouldn't it be their fault if they neglect to get the necessary fix and they now get in an accident caused by the part? Would it still be accidental as necessitated by the policy when they should have known this could happen?

 

Under Part A of the standard personal auto policy, the insurer agrees to pay damages for bodily injury or property damage for which any insured becomes legally responsible because of an accident. By the terms of Part D, the insurer agrees to pay for direct and accidental loss to “your” covered auto or any non-owned auto. Barring the applicability of any other exclusion in the policy, an auto accident caused by a recalled part is exactly the type of unforeseen, unintended, and unexpected event an insurance policy is designed to cover.

 

Although “accident” is not defined in the standard policy, it is generally accepted to be an unforeseen, unintended, and unexpected event, which occurs suddenly and at a definite place. Where the term “accident” as used in an auto liability policy is not defined, courts will determine its definition from the common sense viewpoint of the average person.

 

From one point of view, the nature and purpose of certain types of coverages requires that the question of whether an injury is accidental must be determined from the victim's standpoint. On the other hand, there is the view that an auto policy insures the person who caused the accident, not the victim; therefore (absent any policy language to the contrary) what constitutes an “accident” should be decided from the viewpoint of the wrongdoer. Regardless of which viewpoint forms the basis of a court's determination, the focus will be on reasonable person standard within the context of the specific facts of the particular accident.

 

Further, the term “accident,” as ordinarily used, is a more comprehensive term than negligence and in its common signification means an unexpected happening without intent or design. It has been held that an auto policy covering liability arising from an accident, or from injuries accidentally sustained, covers claims based on the insured's negligence, including the aggravated forms of negligence, such as gross negligence, recklessness, or wantonness. For instance, the court of appeals of Georgia recently held that a county's auto liability insurance policy, which provided coverage of bodily injury “caused by an accident,” included accidents resulting from negligence. The court explained that although the policy specifically excluded bodily injury which is “intentional or expected,” it made no mention of excluding injury caused by negligence. Because the policy did not specifically exclude negligence, negligence was included within the term “accident.” See McDuffie v. Coweta County, 299 Ga.App. 500 (Ga.App., 2009).

 

Therefore, even if it can be argued that the insured was negligent in not getting necessary repairs and therefore should have foreseen or expected an accident to occur as a result, under the language of the personal auto policy the incident was still accidental and his policy should cover it. Many of the recalled vehicles will not show any problem, and it is likely the driver either thinks (or hopes) his vehicle is without issue or simply hasn't had a chance to get it fixed. It is simply unreasonable to expect millions of people to immediately stop driving their cars until they can get the recall part fixed.

 

The bottom line is even if the driver knew or should have known it was possible he would have an accident because of the faulty part, he did not actually expect or intend it.

 

This applies for coverage D, the physical damage portion of the policy, as well. As stated earlier, the policy pays for direct and accidental damage to “your covered auto”. The issue then becomes whether there is an exclusion for the incident, and, if not, is the applicable coverage collision or other than collision?

 

Damage due and confined to mechanical or electrical breakdown is excluded under the personal auto policy. Although the failure of the recalled part may be mechanical breakdown, that breakdown is not due to wear and tear over time. Rather, it is the result of a defective part, thus eliminating the application of the “wear and tear/mechanical breakdown” exclusion. The exclusion is not meant to apply to defective or recalled parts that cause damage to the insured's vehicle or cause the insured driver to lose control of the vehicle.

 

Another issue to consider is whether the loss should be considered collision or other than collision. The rule of thumb is that if the initial loss is an other than collision loss, and that subsequently causes a collision loss, that resulting collision is classified as an other than collision loss. For example, an insured runs over a porcupine that damages the underneath of the vehicle, causing fluid to leak so that the insured runs off the road and into a tree. The porcupine was the first contact; animals are considered an other than collision loss, so while the insured ended up striking a tree, the loss is an other than collision loss.

 

Other than collision losses are losses the insured has no control over—e.g., windstorm, hail, fire, animals, etc. Similarly, the insured has no control over a manufacturer's part in the vehicle failing. There are instances where even when the insured acted appropriately, putting the vehicle in neutral and applying the emergency brake, the car kept going. While an insured with a runaway vehicle may end up hitting a fence, tree, or other vehicle, the loss is still other than collision because the proximate cause of the loss was the failure of the mechanical part.

 

Product Recall

 

Although it is too early to determine how much the recall will ultimately cost Toyota, it is estimated that the dollar amount will reach the billions. Companies involved in recalls typically experience myriad costs, including the cost to investigate the defective product, the expense of returning, repairing, and replacing the affected products, and various other legal and professional fees. A recall can also create a considerable interruption in the company's business and operations, as well as lead to decreased consumer confidence and company credibility.

 

Many manufacturers fail to realize that their commercial general liability (CGL) insurance policies typically will not cover any of the costs associated with a product recall. Although a particular company's insurance coverage depends on the language in its individual policies, the standard form, unendorsed CGL policy specifically excludes many costs and expenses related to the recall of defective products.

 

Under CGL policies, insurers are only required to “…pay those sums that the insured becomes legally obligated to pay as damages because of 'bodily injury' or 'property damage,'” and have the “duty to defend the insured against any 'suit' seeking those damages.” Specifically, the standard recall exclusion, also known as the “sistership” exclusion, provides that the policy will not cover:

 

Damages claimed for any loss, cost or expense incurred by you or others for the loss of use, withdrawal, recall, inspection, repair, replacement, adjustment, removal or disposal of:

 

(1) “Your Product”;

(2) “Your Work”; or

(3) “Impaired Property”;

if such product, work, or property is withdrawn or recalled from the market or from use by any person or organization because of a known or suspected defect, deficiency, inadequacy or dangerous condition in it.

 

The exclusion typically precludes coverage for costs incurred when the named insured's product is withdrawn from the market as a preventive measure. It is intended to apply where the insured's products are recalled because it is suspected that they may contain a defect. Courts have interpreted the sistership exclusion to preclude coverage for claims for damage when, based on the failure of similar products, the insured's products are withdrawn from the market out of concern that they may contain a defect or may cause bodily injury or property damage. See Centillium Commc'ns Inc. v. Atlantic Mut. Ins. Co., 528 F. Supp.2d 940 (N.D.Cal., 2007).

 

Where coverage otherwise exists, the sistership exclusion will not affect recovery of costs incurred attempting to remedy the actual products that have already caused actual bodily injury or property damage. On the other hand, the sistership exclusion will prevent a manufacturer from recouping its costs and expenses if, after learning that some of its products are defective, the manufacturer issues a general recall for all of its products without regard to whether the products are defective. For example, in Atlantic Mut. Ins. Co. v. Hillside Bottling Co. Inc., 903 A.2d 513 (N.J.Super., 2006), the court held that coverage for Hillside's liability to beverage companies for contamination of carbonated beverages was barred by the sistership exclusion in the insured's policy. The recall in this case was general and extending to all beverages that bore the bottling company's plant code, whether they were actually contaminated or not. The court explained that the sistership exclusion excluded the cost of recalling apparently undamaged products to search for damaged components otherwise not yet discovered.

 

The sistership exclusion will generally be held to apply regardless of whether the manufacturer's products are recalled voluntarily or involuntarily. Thus, under the standard form CGL policy, a manufacturer typically will not be able to recoup costs and expenses arising out of a preventive or cautionary recall.

 

One very well-known event where coverage was denied for recall-related expenses was the classic case from 1982 where bottles of Tylenol had been tampered with and poisoned with cyanide. Seven people were left dead in Chicago, and as a result Johnson & Johnson recalled 31 million bottles of Tylenol costing the company $100 million. Their market share dropped dramatically but rebounded within a year.

 

As this was a voluntary recall by Johnson & Johnson and the company did not consult with its insurers beforehand, the carrier denied the claim. Johnson & Johnson contended that its excess liability policy should cover the recall and all expenses. The judge ruled that the recall was not caused by liability for the deaths; rather, it was simply related to the deaths in that the deaths served to notify the company that the product was potentially harmful. The judge also stated that Johnson & Johnson had at one time carried expensive recall coverage but had elected to drop it due to the prohibitive cost.

 

Although a form of product recall insurance was available before the Tylenol event, this type of insurance came to the forefront after that time. Over the years, the coverage has been expanded to include coverage for product extortion, loss of profits from a covered recall event, and loss control and crisis management services for a policyholder, the latter paid for by the insurance company as part of the service package.

 

Although most product recall coverage typically covers only actual recall costs, such as those for the repairs and parts replacements, there are a multitude of vastly varying products available for a wide variety of recall-related costs. Withdrawal-related costs (costs associated with pulling affected products from the stream of commerce and correcting, replacing, and/or destroying such products), communication-related costs (costs associated with notifying consumers about a recall), and personnel-related costs ( costs associated with paying employees, or outside consultants/professionals, to assist with implementation of the various aspects of a recall) can all be insured. Many product recall policies will provide a degree of coverage regardless of whether a recall is government sanctioned or voluntary.

 

Toyota is undoubtedly faced with an enormous amount of recall-related expenses. The actual cost to replace parts, stop production and sale, engage extra staff, offer customers perks from dealers, place ads to try to get market share back, and notify vehicle owners are just a few of these with which the automaker is contending. What, if any, product recall coverage Toyota purchased is unclear, as some companies may not buy recall coverage at all, opting instead to retain the financial risk associated with a large product recall. Still, it is likely that an automaker of Toyota's size has some recall insurance in the international market. Actually replacing accelerator pedals and floor mats, however, should be relatively inexpensive for the company. The true cost to Toyota will come not only from stopping the sale of many of its vehicles, but also from advertising costs to regain lost market share and the potential long-term effects of the damage to its reputation for quality.

 

D&O

 

At the time of this writing, federal prosecutors have opened a criminal investigation into Toyota's safety problems, and Toyota has received a subpoena and a voluntary document request from the U.S. Securities and Exchange Commission (SEC) seeking documents related to unintended acceleration as well as to its disclosure policies and practices. In addition, Toyota has turned over documents to congressional investigators. Some of these documents are said to boast the company saved money by obtaining a limited recall from regulators in 2007.

Toyota is also facing securities-related class action litigation, with suits alleging that Toyota and some of its officers and directors misled investors by failing to disclose design defects, causing its stock to trade at artificially inflated prices during the class period. Among other mounting expenses, the company will be faced with the costs of providing testimony, allowing government access to premises for inspection and testing, and handing over company documents. Such costs may be covered by D&O insurance, which typically provides defense and indemnity of claims made against company officers and directors arising from acts committed in the officers' and directors' official capacities. This includes shareholder suits. The coverage also reimburses a company for amounts it pays to indemnify its officers and directors.

 

In addition, to the extent punitive damages may become an issue, there will be a question as to whether the impacted D&O policies will cover these types of damages. The actual settlements for large D&O cases involve not only actual damages, but punitive damages, and most policies specifically exclude punitive damages.

 

D&O insurance coverage differs from other insurance products in various and significant ways. For example, most companies purchase CGL policies. These policies commonly cover bodily injury, property damage, and personal and advertising injuries while D&O policies do not. In fact, D&O policies specifically exclude coverage for bodily injury, property damage, and personal injury. In addition, while general liability insurers typically have the duty to defend their insureds in the event of a claim, under D&O policies issued to public companies such as Toyota, the insureds have the duty to defend themselves but may be able to seek defense cost reimbursement. As a result, D&O policies issued to public companies often have, with designated exceptions, large self-insured retentions that must be satisfied before the insureds can receive payment for defense costs or other loss. In contrast, CGL policies often have measurably smaller deductibles.

 

With the possibility of criminal charges on the horizon for Toyota, it is important to note that although most D&O policies will exclude coverage for fraud or other criminal activities, many policies include a segregation clause that will allow them to provide defense for the company and other innocent parties that might be pulled into a lawsuit due to a criminal action on the part of someone else.

 

Product Liability

 

Personal injury product liability claims for specific accidents involving Toyotas, as well as consumer class action suits seeking economic damages for diminished use or lost use of a recalled Toyota have also been filed.

 

While coverage generally will be available for claims related to physical injuries or property damage resulting from these automobile accidents, suits seeking economic recovery for allegations such as the diminished value of cars or the loss of use of cars while under repair are likely to raise coverage issues under product liability policies. Insurers may assert that coverage under their policies is available only for claims where there is bodily injury or property damage, but not for the economic damages sought in class action cases.

 

The economic loss doctrine is often implicated in products liability cases when a defective product damages itself without causing personal injury or damage to other property. In this context, “economic loss” is defined generally as “the diminution in the value of the product because it is inferior in quality and does not work for the general purposes for which it was manufactured and sold.” Two types of economic loss, direct and consequential, occur when a defective product is damaged. Direct economic loss may be measured by the defective product's cost of repair or replacement while consequential economic losses, such as lost profits, result from the product owner's inability to use the product.

 

Some products liability insurance policies expressly limit coverage to “tangible” property damage. But even where the policy does not expressly limit the coverage to tangible property, the courts typically determine that such was the intention of the parties. For example, in Lincoln General Ins. Co. v. Detroit Diesel Corp., 293 S.W.3d 487 (Tenn., 2009), the Supreme Court of Tennessee found that the particular damage that resulted from a failure of the insured's product did not constitute injury to or destruction of property as covered by the products liability insurance.

 

In the Lincoln General case, Senators Rental, Inc., an insured of Lincoln General Insurance Company, purchased a bus manufactured by Prevost Car (US) Inc. The engine in the bus was produced by Detroit Diesel Corporation. The bus was traveling on the highway when it caught fire due to an alleged engine defect. The fire did not cause personal injury or damage to any property other than the bus itself. Lincoln General paid Senators Rental for the fire damage pursuant to its insurance policy. The Supreme Court of Tennessee held that the economic loss doctrine precluded the insurer from recovering damages in tort against the bus and engine manufacturers for damage to the bus due to the defect in the engine that caused it to catch fire.

 

In adopting the “majority approach” to the economic loss doctrine, the court followed the U.S. Supreme Court's reasoning from East River Steamship Corp. v. Transamerica Delaval, Inc., 476 U.S. 858 (1986), a ruling in which the court chose a bright-line rule that precludes recovery in tort when a product damages itself without causing personal injury or damage to other property. In reaching this conclusion, the Supreme Court observed that “[w]hen a product injures only itself the reasons for imposing a tort duty are weak and those for leaving the party to its contractual remedies are strong. Specifically, damage to a defective product is merely a failure of the product to meet the purchaser's expectations, a risk that the parties had the opportunity to allocate by negotiating contract terms and acquiring insurance.” Finally, the Supreme Court expressed concern that permitting recovery in tort for purely economic loss could subject a manufacturer to an indefinite amount of damages. A warranty action, on the other hand, has a “built-in limitation on liability.”

 

Similar to when a consumer agrees to purchase a vehicle—even a vehicle with a reputation for durability, quality, and high residual value—there is always a risk that the vehicle will not live up to one's expectations. Because Toyota has provided the opportunity for consumers to correct the defect, in most cases no resulting injury or tangible damage has occurred. The situation may not be desirable or expected by consumers, but that does not necessarily mean alleged economic damages resulting from it would be covered by a products liability policy.

 

Summary

 

The recall of the Toyota vehicles has received significant, widespread attention, and the intense scrutiny of the company is not likely to dissipate any time soon. However, as pointed out earlier, recalls are nothing new. In recent years alone we have seen large recalls concerning toys with lead paint, spinach with e coli, contaminated peanuts, and other products. There are also quite frequently recalls that are much less far-reaching or well-known. Many of these fly under the media radar and go virtually unnoticed by the consumer public.

 

Still, the way a company deals with a recall situation on any scale can hugely impact the company financially, both in the short and long term. The presence or absence of the proper insurance can make a monumental difference in the life of the company after a recall situation. A company with the appropriate coverage has a better chance of rebounding within the market, while the survival of those without may be at risk, depending on the amount of capital they have available to handle the expenses. As with many commercial losses, various coverages may come into play. Understanding these coverages is vital to handling the claims efficiently and expeditiously.