A commercial policyholder can purchase “business interruption” coverage as an option within its property insurance policy. This coverage reimburses continuing expenses and even lost profits during a suspension of business operations — but only if the shutdown was caused by “property damage.”
This property damage prerequisite is usually not an issue when a business has been shut down to recover from a fire, hurricane, or vandalism. The property damage prerequisite is proving to be a very big issue for businesses advancing business interruption claims over COVID-19 lockdown orders.
Under a standard commercial property policy, a business interruption claim cannot proceed without sufficient evidence of property damage:
· For business income coverage, the property damage must occur at the insured location; and
· For civil authority coverage, the property damage must occur within a certain distance (usually one mile) from the insured location.
It is not enough to simply show property damage occurred. For a business income claim to proceed, the property damage must have caused the business to shut down or caused the civil authority to issue an order prohibiting access to the business.
The property damage prerequisite is not some technicality quietly inserted into property insurance policies. The property damage prerequisite is what makes property insurance property insurance — at least according to the rules of insurance regulation, accounting, and income tax.
Before it can do business, an insurance company must be authorized by a state insurance commissioner to write one or more specified “kinds of insurance.” Agents and brokers distributing the insurer’s products must hold a license for that same kind of insurance.
One such kind of insurance is “property insurance.” While definitions may vary somewhat state-by-state, Maryland represents a typical example:
“Property insurance” means insurance on real or personal property on land, in water, or in the air or an interest in real or personal property against loss or damage from any hazard or cause and against loss that is consequential to the loss or damage.
Md. Ins. Code § 1–101(gg).
In other words, a property insurance authorization and license permit the sale and issuance of coverage for property damage and business interruption losses resulting from property damage.
Once an insurance company does draft a property policy, it is usually required to file the form with the state insurance commissioner. Consistent with the insurer’s authorization, a product may be filed as “property insurance” if the:
Coverage protect[s] the insured against loss or damage to real or personal property….
NAIC Uniform Property & Casualty Product Coding Matrix (Jan. 1, 2020).
The property damage prerequisite also marks the line between property insurance and other types of financial services products. For example, the Gramm-Leach-Bliley separates the respective domains of banks and insurance companies by defining “insurance” as:
Any product first offered after January 1, 1999 demonstrated to be one that insures, guarantees or indemnifies against liability, loss of life, loss of health or loss through damage to or destruction of property ….
15 U.S. Code § 6712
Within the boundaries of insurance, the property damage prerequisite keeps property insurance well insulated from the highly specialized and exclusive realm of financial guarantee insurance by exempting a product from financial guarantee regulation:
[I]f the loss is payable only upon the occurrence of … a fortuitous physical event.
NAIC Guideline 1626–1, Sec. 1.A(1) and 2.A.
Accountants rely on the property damage prerequisite to ensure a derivative has not been misclassified as an insurance contract by either insurer or policyholder. The Financial Accounting Standards Board (FASB) exempts a property insurance contract from treatment as a derivative if the:
Payment of benefits is the result of an identifiable insurable event (for example, theft or fire) instead of changes in a variable.
FASB Standard 815–10–15–53. See also IFRS 17, B26 and B27.
In determining whether a contract qualifies for tax treatment as insurance, the Internal Revenue Service distinguishes between contracts transferring “insurance risk” and those transferring “business risk” or “investment risk”. For example, a contract insuring against regulatory change, loss of a major customer or resignation of a key employee involves “investment or business risk” rather than insurance risk. The IRS observes:
[A] fortuitous event (such as a fire or accident) is at the heart of any contract of insurance.”
IRS Private Letter Ruling 2016–09008.
Property Insurance Insures Property Damage
A property insurance policy, including business income coverage, almost always includes a property damage prerequisite to make sure policyholders, intermediaries, and insurers stay on the safe side of insurance regulation, accounting standards and tax rules. It may be possible to design business interruption coverage without a property damage prerequisite, but such a product carries a real risk of falling short of the definition of “property insurance” for regulatory, accounting and tax purposes with serious consequences for bother sellers and buyers.
Policyholders and insurers will spend the next months if not years wrangling over whether COVID-19 causes property damage — and whether this property damage motivated the various states to issue lockdown orders. Perhaps billions of dollars in business interruption claims turn on whether a virus that has killed hundreds of thousands might also have caused microscopic damage to linoleum floors. While it may seem a strange scientific and judicial detour in our nation’s response to COVID-19, a claim under a property insurance policy first requires evidence of property damage.