In November 2005, in the wake of the damage and destruction brought on by Hurricane Katrina and Hurricane Rita, we published a Corporate Insurance Law column in which we discussed insurance claims for flood and wind damage caused by those storms.1 With the Northeast now suffering from the catastrophic harm inflicted by Hurricane Sandy, this column provides an update regarding storm-related insurance issues arising under homeowners’ policies and commercial property damage policies.

Flood Insurance

In 1968, in response to the increasing costs of disaster relief for flood victims, Congress enacted the National Flood Insurance Act, creating the National Flood Insurance Program (NFIP).2 Under the act, each community was mapped to show the probability of flooding in a particular area over the next 100 years. The act established an insurance program that made subsidized coverage available to property owners in at-risk communities in exchange for the communities’ agreement to enforce flood plain management ordinances and other land-use restrictions to reduce the risk of future flood damage. Parts of New York City, including areas in each of the five boroughs, are mapped as eligible under the NFIP as at-risk areas.

Lenders generally require borrowers in at-risk areas to purchase flood insurance as a condition to a mortgage. However, property owners in at-risk areas are not otherwise required to purchase flood insurance, and many property owners in at-risk areas decline to purchase flood insurance. Following a storm, that can leave homeowners searching for coverage under standard homeowners’ policies and commercial property owners searching for coverage under all risk or named peril property damage policies. Unfortunately, in the case of homeowners, whether or not there is coverage may turn on the fortuity of whether the storm damage was caused predominantly by wind instead of water.

Commercial property policies are also likely to contain flood exclusions. However, such policies may also offer business interruption coverage, which may potentially provide coverage for business loss not subject to a flood exclusion. In the case of business interruption insurance, whether there is coverage may turn on a number of issues, including whether there was actual physical damage to property owned by the insured, or in some cases to property owned by a supplier or customer of the insured.

Homeowners’ Insurance

Generally speaking, unless an insured purchases specific flood insurance, a homeowners’ policy will exclude coverage for damages caused by flooding.

Standard flood exclusions typically bar coverage for “flood, surface water, waves, tides, tidal waves, overflow of any body of water, or their spray, all whether driven by wind or not….” Water that backs up from a sewer or drain may also be excluded or, in some cases, may be subject to a separate lower policy limit.

Many homeowners’ policies do expressly provide coverage for damages caused by wind or hurricanes. When homes are damaged by a hurricane, that can lead to a dispute over whether the damages were caused predominantly by flooding, which would be excluded, or by high winds, which may be 
covered.

Despite our fair share of Nor’easters and other storms over the years, and despite the fact that four of the five boroughs are islands, there is surprisingly little New York case law addressing insurance coverage disputes over flood and wind issues. We reviewed most of these cases in our 2005 column and found that flood exclusions were generally enforced by the courts, although there were several cases in which the court held that whether damage was caused by wind or water was an issue of fact to be determined at trial. Although there have not been any additional New York cases of particular interest since our prior column, there have been a number of relevant cases in other jurisdictions concerning insurance claims under homeowners’ and commercial policies for damages caused by Hurricane Katrina.

Hurricane Katrina Cases

In several cases, insureds have attempted to challenge the application of the flood exclusion to damages caused by Hurricane Katrina. For the most part, these challenges have been unsuccessful. In Corban v. United Services Automobile Association,3 the insureds sought coverage for hurricane damage to their two-story residence under both a homeowners’ policy and flood policy issued by the United Services Automobile Association (USAA). The flood exclusion in the homeowners’ policy barred coverage for “water damage, meaning: (1) flood, surface water, waves, tidal water, overflow of a body of water, or spray from any of these, whether or not driven by wind….”4

USAA paid out the limits of the flood policy, but denied coverage under the homeowners’ policy for all damage to the first-story living area based on the flood exclusion, because the first floor damage was determined to be caused by “flooding and wave wash.” Plaintiffs argued that the flooding of the first floor was caused by storm surge and that, since storm surge is not explicitly excluded, the flood exclusion did not apply. The Supreme Court of Mississippi rejected this argument, finding that storm surge, a synonym for wind-driven water, is included within the water damage exclusion. However, the court did remand the case for a determination as to what damage was caused by wind and what damage was caused by flood, including storm surge.5

In Northrop Grumman v. Factory Mutual Insurance,6 the U.S. Court of Appeals for the Ninth Circuit also rejected the insured’s attempt to argue that damage caused by storm surge was not barred by the flood exclusion. In that case, the insured’s Mississippi shipyards were pounded by winds of up to 175 miles per hour and flooded by storm surge as high as 22 feet during Hurricane Katrina.

The insured sought coverage under primary and excess commercial all-risk policies issued by Factory Mutual. Both the primary and excess policies contained a flood exclusion, but the insurer paid out the limits of the primary policy for wind damage. The insured argued that the flood exclusion in the excess policy was not applicable to storm surge damages, because the definition of flood did not expressly include the phrase “whether driven by wind or not.” The Ninth Circuit rejected this argument, finding that the absence of this phrase did not confer coverage for damages due to flooding caused by storm surge.7

In In re Katrina Canal Breaches Litigation,8 plaintiffs, a group of policyholders with homeowners’, renters or commercial property policies, sought coverage for damages sustained due to flooding resulting from the breaches or overtopping of levees in the aftermath of Hurricane Katrina. The plaintiffs contended that the flood exclusion did not bar coverage because the actual cause of the damages was the negligent design, construction and maintenance of the levees. The U.S. Court of Appeals for the Fifth Circuit rejected this argument, finding that the inundation of water into the city of New Orleans constituted a flood within the meaning of the policy and therefore that the claims were barred by the flood exclusion.

Likewise, in Sher v. Lafayette Insurance, the Supreme Court of Louisiana upheld the application of the flood exclusion to claims for water damage to an apartment building caused by flooding when the levees that protected New Orleans failed.9

Commercial Property

Commercial property owners may have coverage for storm damage under their first party property damage policies or, in some cases, under fire insurance policies. First party property coverage is typically available in two forms. All risk policies generally cover direct physical loss regardless of cause, unless the cause is specifically excluded. Named peril policies generally cover direct physical loss for listed perils, subject to policy exclusions.

In addition to covering standard property damage risks, commercial property insurers may offer business interruption coverage or contingent business interruption coverage. Business interruption coverage typically provides coverage for loss of income or profits resulting from the interruption of business operations caused by physical damage to the insured’s property resulting from a covered peril. In contrast, contingent business interruption coverage typically provides coverage for loss resulting in the interruption of business operations due to direct physical damage to the property of a supplier or customer of the insured. Such coverage may also cover the risk of extra expense incurred during the time of loss until the return of normal operations.

Some insurers also offer coverage for business interruption loss caused by the order of a civil authority, for example, where a local government prohibits access to an area. In addition, some policies may provide coverage for business interruption loss caused when ingress or egress to the insured’s property is prevented or by direct physical loss of utility services to the insured’s property.

While business interruption coverage may not be subject to a flood exclusion, due to the terms of these policies, case law concerning business interruption claims often focuses on whether the loss was caused by direct physical damage to the insured’s property, or in the case of contingent business interruption coverage, whether there has been direct physical damage to the supplier or customer’s property.

Direct Physical Damage

Case law concerning insurance disputes over business interruption loss incurred in connection with the terrorist attack on the World Trade Center is instructive. For example, in Penton Media v. Affiliated FM Insurance,10 the insured sought coverage for loss incurred when a trade show scheduled to take place at the Jacob Javits Center was cancelled in the aftermath of the attack on the World Trade Center. The insured had purchased contingent business interruption insurance which provided coverage for loss “resulting from direct physical loss or damage insured by this policy occurring at each supplier and customer location(s).”11 The policy also provided coverage for loss incurred when access to the insured location “is prohibited by order of civil authority.”

On appeal, the U.S. Court of Appeals for the Sixth Circuit affirmed the order of the District Court, finding that the insured was not entitled to coverage because there was no direct physical loss to the property of a supplier or customer and because the order of civil authority barred access to the Javits Center, not the insured’s property.12

Similarly, in Arthur Andersen v. Federal Insurance,13 the insured accounting firm sought to recover lost profits allegedly attributable to property damage to the World Trade Center under a contingent business interruption coverage part. Pursuant to the terms of the insurance policy, such coverage was available only where there was damage to “[p]roperty that directly or indirectly prevents a supplier of goods, services or information to the Insured from rendering their goods, services or information or property that directly or indirectly prevents a receiver of goods, services or information from the Insured from accepting or receiving the Insured’s goods, services or information.”14 The New Jersey Appellate Division upheld the order denying plaintiff’s claim, because plaintiff could not demonstrate that any loss was caused by damage to the property of a client or supplier at the World Trade 
Center.

In contrast, in Zurich American Insurance v. ABM Industries,15 the U.S. Court of Appeals for the Second Circuit found that the insured had a right to coverage for business interruption loss and was also potentially entitled to coverage under the civil authority coverage section. The insured, a contractor that provided janitorial and HVAC services in common and tenant areas of the World Trade Center, sought coverage for business interruption loss as a result of the terrorist attack.

The Second Circuit, reversing the Southern District, held that the insured had a right to recover business interruption loss because the loss resulted from property damage to common areas and premises used by tenants. In addition, the Second Circuit held that there was potential coverage under the civil authority coverage part to the extent that the insured had incurred loss due to civil orders preventing access to other properties serviced by the
insured.

In another case concerning executive order coverage, the Circuit Court of Virginia, in U.S. Airways v. Commonwealth Insurance,16 upheld U.S. Airways’ claim for business interruption loss incurred as a result of the ground stop orders issued by the Federal Aviation Administration and the closing of Reagan National Airport in the days following the attack on the World Trade Center.

Looking Forward

Unfortunately, Hurricane Sandy caught many people in the private and public sector, homeowners, commercial property owners and government officials, by surprise. The coming months are likely to include substantial debate over how to best protect public and private property as we head toward a future that climate scientists predict will include more frequent storms of high intensity. One way to protect property owners is to ensure that smart decisions are made about available insurance. Now is a good time for property owners to review their current policies and consider whether they are protected to the extent appropriate from the risks associated with future storm damage.

Howard B. Epstein is a partner at Schulte Roth & Zabel, and Theodore A. Keyes is special counsel at the firm.

Endnotes:

1. Howard B. Epstein and Theodore A. Keyes, “Wind vs. Water: Insurance Coverage for Storm Damage,” New York Law Journal, Volume 234, No. 103, Nov. 29, 2005.

2. Testimony of Robert Hartwig, Chief Economist, Insurance Information Institute, before Senate Committee on Banking, Housing and Urban Affairs, 2005 WLNR 1168874433 (Oct. 18, 2005) at 2-3.

3. Corban v. United Services Automobile Association, 20 So.3d 601 (Miss. 2009).

4. Id. at 610.

5. Id. at 616.

6. Northrop Grumman v. Factory Mutual Insurance, 563 F.3d 777 (9th Cir. 2008).

7. Id. at 784-785.

8. In re Katrina Canal Breaches Litigation, 495 F.3d 191 (5th Cir. 2007).

9. Sher v. Lafayette Insurance, 988 So.2d 186 (La. 2008).

10. Penton Media v. Affiliated FM Insurance, 245 Fed.Appx. 495, 2007 WL 2332323 (6th Cir. Aug. 15, 2007).

11. Id. at 498.

12. Id. at 500.

13. Arthur Andersen v. Federal Insurance, 416 N.J. Super. 334, 3 A.3d 1279 (Sup. Ct. App. Div. 2010).

14. Id. at 347.

15. Zurich American Insurance v. ABM Industries, 397 F.3d 158 (2d Cir. 2005).

16. US Airways v. Commonwealth Insurance, 2004 WL 1637139 (Va.Cir.Ct. July 23, 2004).