Special Millennium Issue

CLAIMS LAW UPDATE

Y2K COVERAGE ISSUES

by Kim V. Marrkand, Esq.*

[ref: Law of Insurance: General Liability
and Commercial Property Coverage]

As the millennium approaches, most people are now familiar with the “Year 2000 problem,” also known as “The Y2K problem.” The Y2K problem refers to the inability of some computer systems, including embedded chips, to process dates after the turn of the century. Many technology experts predict the cost of correcting the problem may reach hundreds of billions of dollars. Experts also expect the Y2K problem to precipitate extensive litigation that may far exceed what the insurance industry experienced in environmental and asbestos litigation. Policyholders will look to their carriers to cover their losses, and insurance coverage disputes are inevitable. To date, Y2K coverage litigation has already commenced and these first cases, currently in the early discovery phases, should be closely watched.

Given the expected nature of Y2K claims, several coverage lines are implicated. For example, claims may impact commercial general liability (“CGL”), first party property, directors and officers (“D&O”), and errors and omissions (“E&O”) policies. The list of potential Y2K claimants is unlimited and Y2K coverage disputes are likely to involve several issues of first impression.

CGL POLICIES

The starting point for any coverage claim is a two-pronged question: (1) does the claim assert a liability that falls within the grant of coverage; and (2) is the coverage eliminated because of an exclusion, term or condition of the policy. CGL insurance is coverage that provides defense and indemnification when an insured is sued by third parties for damage covered by the policy. A CGL policy typically offers bodily injury, property damage, personal injury, and advertising injury coverage. CGL insurance is intended to protect insureds against tort liability arising out of their negligence. For a loss to be covered under a CGL policy, Y2K driven or not, the claim must allege an accident or occurrence resulting in bodily injury or property damage as defined in the policy, during the policy period.

The first issue involved in a potential Y2K claim is whether an occurrence or accident as defined in the policy took place. Absent an accident or occurrence, there is no liability coverage under a CGL insurance policy. The policy definitions of accident or occurrence implicate the doctrines of fortuity and known risk and known loss, each of which is inherent in the concept of risk shifting. Fortuity means that any insured loss must be accidental and random. This fundamental principle prevents the policyholder from passing to its insurer losses that the policyholder intends, controls, knows or should know will happen.

The Y2K problem is the result of a computer programming convention intended to save memory space. Since the problem was caused by the deliberate decision of programmers, resulting losses are arguably not fortuitous. Policyholders seeking coverage will have to explain why they elected not to remedy the problem since the Y2K problem arose by choice, not by chance. CGL insurance policies do not cover losses that were the result of intentional programming decisions and not a result of a fortuitous event or accident.

For example, courts have ruled that volitional asbestos removal costs incurred by the insured, as a prerequisite to demolishing a building, were not covered under the standard CGL policy. Also, courts routinely preclude coverage for a liability when an insured knows, when it purchases a policy, that there is a substantial probability that it will suffer or has already suffered a loss. Insureds will point to a contrary line of cases that hold an insurable risk does exist as long as insureds do not know their liability at the time the policy was issued.

Questions regarding the trigger of coverage will also create debate. The trigger issue deals with whether the direct physical harm occurred during the period of the applicable policy. Trigger of coverage relates to timing and is particularly important for Y2K claims because more recent policies may contain exclusions that reduce available coverage and policyholders will also want to trigger earlier policies to maximize coverage.

Previous environmental and asbestos litigation resulted in numerous conflicting state and federal decisions regarding the trigger issue. Some courts have adopted a “manifestation” or “first discovery” trigger, which holds that the policy in effect at the time the property damage or bodily injury manifests is applicable. Other courts adopted an “exposure theory,” whereby only those policies in effect during the time the claimant was exposed to asbestos were implicated. Still other courts have adopted a “continuous trigger” theory. Under this theory, where there is evidence of progressive damage, all policies in effect from the date of exposure to the product, until discovery of the damage are triggered. Some courts have adopted an “injury-in-fact” trigger. Under this theory, the policies that are in effect whenever the harm actually occurs, as determined under the facts and circumstances of each case, are triggered. Finally, in applying the “installation-trigger” theory, courts have held that only the installation of the harmful product triggers coverage. We believe that insureds will assert that either an “installation” of software or a “date of purchase” of software trigger applies, avoiding any pertinent Y2K exclusions.

The next issue in a property damage claim is whether the claim is one for property damage as defined in the typical CGL policy. For guidance, courts will likely look to cases involving the incorporation of a defective product into another properly functioning product. The issues in construction defect case law are similar to what we can expect in Y2K litigation.

CGL policies require that the injury be physical injury to, or destruction of, tangible property. Some courts preclude coverage where the defective installation allegedly decreased the economic value, but did not cause physical harm to the overall structure. Policy- holders will likely point to Eljer Manufacturing Inc. v. Liberty Mut. Ins Co., 972 F2d 805 (7^th Cir. 1992) to argue that defective installation constitutes physical injury. The Eljer court held that diminution in value sufficiently constituted property damage, in its case involving a structure with potentially defective plumbing that had not yet failed. The court concluded that “physical” did not require physical destruction or alteration, but simply that some physical contact or linkage caused the diminution in value.

In Eljer, the court likened the defective plumbing system to a “ticking time bomb.” The court concluded that the purpose of insurance would be thwarted if the policyholder could recover only after the plumbing system caused actual physical alteration of the property. This time bomb theory will be utilized by policyholders seeking CGL coverage for Y2K claims. Policyholders will argue that the Y2K problem arises out of defective software that is incorporated into a larger computer system which acts as a ticking time bomb, thereby threatening the policyholder’s property and business.

In Seagate Tech.,Inc. v. St.Paul Fire and Marine Ins. Co., 11 F. Supp.2d 1150 (N.D. Cal. 1998), the first reported case involving the duty to defend a Y2K-related claim, a California federal district court declined to accept the Eljer rationale. In Seagate, a disk drive supplier sought coverage from its insurer for an underlying suit filed by a personal computer manufacturer seeking damages for allegedly defective disk drives that were incorporated into the plaintiff’s computers. Seagate sought coverage from its general liability insurers who disclaimed on the grounds that the defective disk drives caused no physical damage to the computers. Seagate argued physical damage occurred because the disk drives were incorporated into, and therefore physically damaged, the host computer. The insurers argued that mere incorporation of a defective product into another does not constitute or cause physical damage to tangible property. In rejecting the policy- holder’s arguments, the court held that no duty to defend existed because the incorporation of a defective disk drive into a host computer did not constitute physical injury. The court distinguished the asbestos cases on the grounds that asbestos, in contrast to a disk drive, is an inherently dangerous product.

Other aspects of CGL coverage may also be implicated. The CGL’s property damage definition requires that the damage occur to tangible property. Whether software and electronic data constitute tangible property, for these purposes, will be hotly contested. Some courts have defined tangible property as property which can be handled, touched or physically possessed. Other courts have held that electronic data is not tangible and, thus, no injury to tangible property occurs unless there is injury to the medium upon which it is stored.

Even if a claim complies with the requirements of the general insuring agreement, certain exclusions may still preclude coverage for a Y2K claim. The CGL policy expressly excludes coverage for bodily injury or property damage expected by the insured. Given the widespread knowledge and awareness of the Y2K problem, the expected or intended exclusion will be an important battleground in cases seeking coverage for aY2K claim under a CGL policy. One important consideration in this context is whether the jurisdiction adopts a subjective or objective standard in determining whether harm was expected or intended by the insured.

The business risk exclusions will also provide insurers valid grounds to deny coverage for Y2K claims under a CGL policy. The business risk exclusions ensure that coverage does not include losses that result from poor business performance. The CGL form also excludes coverage for property damage to the policyholder’s product or work as each is defined in the policy. The purpose of the business risk exclusions is to preclude coverage for repair and replacement costs that result from the policyholder’s defective work or product.

The business risk exclusions may arise in cases where computer hardware/software vendors seek coverage for claims instituted by customers complaining of Y2K problems. The key question for operation of these exclusions is whether the alleged Y2K deficiency caused property damage to property other than the product or work supplied by the policyholder. To use a common example, if an automated production line supplied by the policyholder ceased to operate because of a Y2K problem, claims asserted against the policyholder for this harm should be excluded by the business risk exclusion because the damage is limited to the product supplied by the policyholder. If a Y2K problem caused a sprinkler to malfunction during a fire, a claim for other property damaged by the fire would not necessarily be barred by these business risk exclusions.

The CGL policy also includes an impaired property exclusion that bars coverage for property damage to impaired property, or property that has not been physically injured, arising out of defective work or products of the insured. The impaired property exclusion bars coverage for loss of use claims where the loss was caused by failure to provide a product or work with the quality expected. The exclusion is an attempt by insurers to exclude damages arising from a breach of representations or warranties made by the named insured as to the level of performance of its products.

Policyholders will argue that sudden system crashes caused by the Y2K problem should trigger the sudden and accidental physical injury exception to the impaired property exclusion. Whether this argument will prevail will depend in large part on the court’s interpretation of physical injury and the facts of the underlying case. The impaired property exclusion will be important in any claim which is based solely on the failure of a computer or system to work as represented because of a Y2K software problem. The exclusion is likely to bar coverage if the system can be repaired by upgrading or replacing the software.

Many policies now contain endorsements that specifically exclude losses that result from the Y2K problem. A typical Y2K exclusion provides that the insurance does not apply to “bodily injury” or “property damage” arising directly or indirectly out of the Y2K computer date change. As this is a new exclusion, it too will be vigorously litigated. As with any such exclusion, we should anticipate that policyholders will seek to discover its drafting and regulatory approval history.

FIRST PARTY POLICIES

First party insurance claims generally arise in the context of named-peril or all-risk policies. Within these policies, the questions become whether coverage exists for repair costs and/or business interruption. First party property damage coverage generally indemnifies an insured for fortuitous property damage to insured property owned by the policyholder, subject to express exclusions. Business interruption coverage is generally included as an endorsement to first party policies to insure against losses sustained as a result of suspensions in business operations. The issues and defenses raised in the first party context are similar to those in claims arising under CGL policies in the third party context previously discussed. For example, the prior discussion of fortuity equally applies to first party policies.

Typically, first party policies require physical loss or damage to real or personal property arising out of a covered cause of loss. A named-peril property policy covers losses caused by specific named perils identified in the policy. An all-risk property policy covers any physical loss or damage, unless specifically excluded. It is extremely unlikely that a Y2K problem would fall within a covered cause of loss in a named peril policy. Yet, a Y2K problem could be at the root of a “covered cause of loss,” i.e. sprinkler leakage, fire, smoke, etc., given the broad scope of the potential Y2K problem.

In order for the policyholder to obtain coverage under a first party policy, the policyholder must show the existence of “insured property” which has suffered “direct physical loss or damage” arising out of an “accident” or fortuitous event. Physical loss or damage is not usually defined in all-risk policies. The “ticking time bomb” theory, first stated in Eljer, will likely be used by policyholders as a basis for arguing physical loss or damage under all-risk policies. The Eljer interpretation of the meaning of the phrase physical injury in CGL policies will be argued by analogy in Y2K first party claims. Unlike with CGL policies, the issue of what constitutes “physical loss or damage” within the meaning of all-risk policies has rarely been litigated in a context analogous to the Y2K problem. Thus, insurers will argue by analogy for a restrictive reading of the Eljer case, while policyholders will argue that Y2K first party claims are included within the Eljer analysis.

BUSINESS INTERRUPTION

As a result of the Y2K problem, many companies’ operations may cease for a certain period. The loss in business, and the extra expenses incurred while operating under such circumstances, may be covered under first party policies. This second form of first party coverage that may be available for Y2K damages may be found under time element, or business interruption (collectively “business interruption”) provisions. Generally, there are three types of business interruption coverage that may cover such claims: business interruption, extra expense, and expense to reduce loss provisions. Business interruption coverage reimburses the policyholder for business losses as a result of having to shut down operations because of a covered loss. Alternatively, extra expense and expense to reduce loss provisions attempt to cover the costs involved with dealing with such circumstances.

Recovery under a business interruption provision requires a total suspension of the insured’s operations. A decrease in the insured’s productivity does not trigger the coverage. Unless the particular policy form allows coverage for partial suspension of operations, the “business interruption” coverage will not apply in the absence of a complete cessation of operations. The complete cessation requirement is likely to seriously limit the availability of coverage from “business interruption” provisions. Specific Y2K exclusions will also restrict “business interruption” coverage.

Both commentators and insureds have argued that the sue and labor clause triggers coverage for an insured’s Y2K remediation costs. Such arguments, however, overlook that sue and labor clauses are predicated on mitigating an insurable loss. The standard sue and labor clause obligates the insured to safeguard and preserve insured property in order to prevent further loss for which the insurer would be liable. Because in the first instance there was an insurable loss, the insurer subsequently reimburses the insured for the costs incurred in mitigating the damage. As Y2K costs do not result in insurable losses, sue and labor clauses should not require an insurer to indemnify an insured for remediation costs. Despite this argument, however, sue and labor clauses are presently being litigated nationwide in Y2K coverage litigation. To date, at least four such sue and labor coverage suits have been filed.

OTHER LIABILITY INSURANCE POLICIES

In addition to the CGL and first party policy coverage issues, the Y2K problem will implicate other types of insurance.D&O policies will be targeted by insurers to respond to litigation related to managing the affairs of a corporation. Shareholders have already initiated derivative suits and purchasers or sellers of securities have already instituted securities fraud claims asserting that officers failed to prepare for Y2K and/or made misleading statements with respect to a company’s Y2K preparedness.

E&O policies will also become involved in Y2K litigation. E&O policies insure professionals and in-service businesses, such as software designers, investment advisors, and consultants for claims asserted against them arising out of their professional services in the conduct of their business. The policies are typically written on a “claims made” basis and require the insurer to defend and indemnify the insured for claims made during the policy period against the insured due to any negligent act or omission by the insured in the conduct of its business as a consultant. E&O policies will not respond to losses of which the policyholder was aware or which should be disclosed on the application. If a policyholder fails to disclose the existence of a Y2K liability, then the insurer may argue misrepresentation to deny coverage.

CONCLUSION

In responding to Y2K coverage disputes it is important to keep in mind that these disputes implicate multiple insureds and multiple lines of coverage. The first cases to be decided will have enormous implications for the industry, depending on the type of insured, the line of coverage and the jurisdiction. Claims handling in the first wave of Y2K claims will be critical. Failure to recognize a Y2K claim could result in wrongful denial or, conversely, wrongful acceptance. Either way, insurers are likely to be targeted and criticized for their Y2K claims handling and arguments will be about inconsistent coverage positions. Awareness, training and vigilance will be major factors in the insurance industry’s successful handling of the Y2K problem.

*Kim Marrkand is an attorney with Mintz, Cohn, Ferris, Glovsky and Popeo, P.C. - One Financial Center - Boston, Massachusetts. She is a member of the firm’s Litigation Section, and the chair of the Insurance/ Reinsurance Group. Ms. Marrkand has represented insurers in courts throughout the country; has briefed, argued or tried virtually every relevent Y2K coverage issue; and frequently speaks and writes on coverage issues. She was a speaker at the 1999 SCLA Conference. The author acknowledges the assistance of Steven J. Torres, Esq

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