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The Y2K Bug: Will Insurance Carriers be Stung by a Swarm of Claims?

January 1, 1999

It's a safe bet that many insurance claims will be forthcoming after January 1, 2000, but will insureds be able to collect?

© International Association of Defense Counsel, Inc.

This article originally appeared in the January 1999 issue of Defense Counsel Journal (66 DEF.COUNS. J. 17 (1999) and is reprinted with permission. ©International Association of Defense Counsel, Inc.

IADC member Michael J. Brady is a partner in the Redwood City, California, office of Ropers, Majeski, Kohn & Bentley and is chairman of the firm's appellate, insurance coverage and bad faith departments. He is a graduate of Stanford University (1964) and Harvard Law School (1967).

Geneva Wong Ebisu is an attorney in the same firm. She is a graduate of the University of Hawaii and the Santa Clara University School of Law.

By Michael J. Brady and Geneva Wong Ebisu

WHAT IF you woke up on January 1, 2000, and learned that you owed millions of dollars in interest on an outstanding debt of ten dollars? What if you or a family member needed emergency health care but couldn’t get it because the computers had crashed at all the hospitals? What if you tried to withdraw money from your bank account and found that your savings balance had been erased? What if millions of businesses and governments worldwide that rely on computers were forced to suspend operations indefinitely because the computers had all malfunctioned on New Year's Day 2000?

How about another frightening scenario. What if all the losses resulting from computer malfunction on January 1, 2000, were submitted as insurance claims? Could any insurance carrier survive the onslaught?

THE FIX WE'RE IN,

AND HOW TO FIX IT

If you haven't before given much thought to the potentially catastrophic computer problem--known variously as the "millennium bug," the "Y2K problem" or the "Year 2000 problem," your days of apathy are numbered. The Y2K/millennium bug, in a nutshell, is the result of the inability of most computer systems in operation today, if they haven't been fixed, to distinguish between the year 2000 and the year 1900.

That deceptively trivial problem has its genesis in the original programming of computers in the 1970s. In those days, computer memory was so precious that programmers elected to use only two digits, instead of three or four, to designate a year. A majority of computer programs and thousands of electronic consumer products in use today still have this programming glitch in their software. Because most computer system memories are date-dependent, those uncorrected systems, when faced with the anomaly of a year with three zeroes, will become confused. They then could come crashing down like the big ball on Times Square at the stroke of midnight December 31, 1999.

The fix for these systems is not as simple as one might think. The programming for the date is invariably buried in millions of lines of computer code requiring huge numbers of hours to locate and fix. Because of the enormous number of man-hours required to make most of the computer systems in the country compliant, it has been estimated that nationwide repair costs will reach $227 billion, with about $100 billion of that representing litigation expenses./1/ Worldwide costs to correct the Y2K Bug could reach $400 to $600 billion/2/--not just in business, but also for, among others, problems in government, healthcare, transportation, and communications. Legal costs could easily exceed $1 trillion, with liability arising from the failures of mainframe computers, personal computers and thousands of products containing embedded microchips with the Y2K bug./3/

The number of skilled programmers fluent in the antiquated programming languages in which most computer code was written is already scarce because these languages are no longer routinely taught. Organizations that have begun seeking a fix for their systems have already snapped up the services of the dwindling number of skilled programmers. It is estimated that many companies, however, even with the specter of catastrophe looming over them, have not even begun to address the problem.

As the year 2000 approaches and more information about the Y2K Bug is disseminated, only then will many businesses begin to seek a fix. The increasing scarcity of competent programmers, however, will likely result in many companies not being able to obtain a fix for their systems before January 1, 2000. The result? The doomsday scenarios only envisioned now could become a reality.

The gamut of damages that could conceivably be attributed to the Y2K problem is virtually limitless in view of the pervasive usage of computers in all aspects of the global society. Although we may not be aware of it, computers are used in governments, in most large industries, in many small businesses, by financial institutions, by transportation systems, in military and intelligence systems, in public safety systems, by medical providers, by factories, by telecommunications systems, by power generators, and by educational institutions. Not one of these entities is immune from the Y2K bug because of the complex interrelationships among them. Even if, for example, a business managed to completely implement a fix, it still must deal with suppliers or lenders who may not have had the foresight or the wherewithal to resolve their own computer problems.

If thousands or millions of businesses begin failing and losses begin mounting, the inevitable finger-pointing will begin. Those most at risk for liability will be businesses who should have known of the dangers of not correcting their computer systems but did not do so, or did not do so adequately. Also at risk are the many companies involved in the supply of computer systems and software, from the computer manufacturers, designers, and programmers to the vendors and end suppliers. The snowball effect of litigation no doubt will draw in as defendants anyone who might possibly be blamed.

When the full force of the Y2K problem is felt, will insurance carriers be on the hook for the inevitable swarm of claims? There are various types of first- and third-party insurance carried by most businesses and organizations in the United States. First, the comprehensive general liability (CGL) policy is the type of third-party, or liability, coverage most commonly used by businesses. Second, many also carry directors and officers (D&O) liability insurance and errors and omissions (E&O) policies. Third, most businesses and organizations also have first-party property insurance, and some also carry business interruption coverage.

INSURERS PREPARE

More than a year ago, the insurance industry requested the Insurance Services Office (ISO) to draft Y2K exclusions. It has prepared exclusions tailor-made for each state. In late 1998, the exclusions had been approved generally in 48 states, Maine and Massachusetts being the exceptions.

These exclusions, depending on which are used by the insurer, can be employed to preclude coverage for third-party claims, first-party claims, D&O claims, E&O claims, and products/completed operations. In other words, an all-inclusive set of the ISO Y2K exclusions would preclude coverage for any exposure associated with the Y2K phenomenon.

One economic question that arises is whether the insurance industry will utilize these exclusions on an extensive basis. The American insurance market in the late 1990s is "soft," otherwise known as a buyers' market. Many traditional customers of the industry are looking for other forms of protection besides traditional insurance. This makes traditional insurance very competitive and customer-orientated. Many insurers may choose not to engraft the Y2K exclusions onto their policies, especially when their customers are large corporations and businesses. If the insurer is insistent, the customer may simply leave, go to another insurer, or exit the traditional insurance market altogether. Negotiating power is probably with the large policyholder, not with the insurer.

Legally, the Y2K exclusions raise other intriguing issues. The ISO announced that the exclusions are simply "clarifications" of the existing coverage, meaning that coverage never existed under current policies. Insureds undoubtedly will argue that if existing policies needed to be clarified, then existing policies were ambiguous, and therefore any claims falling within existing policies (that is, arising before the Y2K exclusions were issued) would be covered. Or insureds will argue that the fact that the Y2K exclusion were issued suggests that there was coverage under existing policies. Otherwise, why would an exclusion be necessary?

Nonetheless, it is the opinion of these authors that if the damages at issue happen after the proper issuance of a Y2K exclusion, the exclusion will probably be enforced so as to preclude coverage for Y2K-related damages.

But, with the stakes so enormous, the insurance industry would be naïve to believe that large sophisticated businesses will give in on this issue, and complicated litigation can be expected.

Regardless of the new exclusions, this article examines all these types of insurance policies in the context of probable Y2K-related claims.

CGL POLICIES

A. Policy Form

A typical CGL policy (Form CG 00 01 10 93 of the Insurance Services Office) has the following insuring agreement:

COVERAGE A. BODILY INJURY AND PROPERTY DAMAGE LIABILITY

1. Insuring Agreement

a. We will pay those sums that the insured becomes legally obligated to pay as damages because of "bodily injury" or "property damage" to which this insurance applies. . . .
b. This insurance applies to "bodily injury" or "property damage" only if:

(1) The "bodily injury" or "property damage" is caused by an "occurrence" that takes place in the "coverage territory;" and

(1) The "bodily injury" or "property damage" occurs during the policy period. . . .

B. No Coverage for Breach of Contract

It is a widely accepted principle of insurance law that liability policies generally provide coverage only for tort liability, and not for contract liability. Therefore, a liability insurance policy would not provide coverage for an insured’s liability for failing to perform a contractual obligation./4/ Likewise, many jurisdictions, like California, have consistently interpreted the phrase "legally obligated to pay as damages," as used in the insuring agreement of CGL policies, to cover only tort liability and not liabilities arising in contract./5/ Liability is said to be purely contractual where it depends on the existence of a contract./6/

Although some liability policies include an endorsement for "blanket contractual liability," that endorsement does not cover breach of contract liability on the part of the insured. Rather, the endorsement is held to cover only the tort liability of a third party that the insured has assumed by contact./7/ This would include indemnification and hold harmless agreements.

Accordingly, if alleged liability for damages arising from a Y2K problem can be found to be a purely contractual claim, a CGL policy would not be obligated to cover the claim. An example would be an organization that sues its computer or software supplier for damages under a breach of contract claim alleging that the system is not Y2K compliant. This claim would not be covered under a CGL policy because it is based only on contract liability, and for tort liability.

C. Requirement of Fortuity

Perhaps the most essential ingredient in the area of insurance coverage is the element of fortuity--that is, the requirement that risks, in order to be covered, must be unexpected, unknown events occurring in the future./8/ A loss that is deliberately caused by an insured is not covered./9/ A risk that is already known or apparent at the time the insurance contract is entered into also is an uninsurable risk./10/

In Morton Thiokol Inc. v. General Accident Insurance Co. of America, the New Jersey Superior Court stated:

Insurance provides financial protection against risks that may someday occur. Once a risk becomes a certainty, it is no longer insurable. Any insurance acquired subsequent to the act, the harm, and the notice thereof, is not valid as to those acts and that harm./11/

The fortuity element is addressed by occurrence-based CGL policies in both the insuring agreement and in the exclusions. In older (pre-1986) policies, an "occurrence" was defined as an "accident . . . neither expected nor intended from the standpoint of the insured." Newer (post-1986) policies require that losses be caused by an "occurrence," which ISO Form CG 00 01 10 93 defines as "an accident, including continuous or repeated exposure to substantially the same general harmful conditions." Occurrence is then defined in the policies as an "accident."

There is an issue as to whether claims caused by the inclusion of non-Y2K compliant software would even constitute an "occurrence" or an "accident" under these insuring clauses. The decision to use only two digits, instead of four, to indicate a year was not an accident. Rather, it was a deliberate and intentional choice to save programming space when the software was developed. Therefore, at the outset, a policyholder who is sued for damages caused by providing a system or product with the Y2K bug will have the difficult hurdle of showing that the claim falls within the insuring provision of a CGL policy requiring that a loss be the result of an accident.

A policyholder also would need to contend with specific exclusions stated in the policies. The post-1986 policies exclude, "'Bodily injury' or 'property damage' 'expected or intended' from the standpoint of the insured."

In a CGL policy both the terms "expected" and "intended" are used to address the fortuity requirement by further qualifying what is covered as "bodily injury" or "property damage." In common English usage, the words "expect" and "intend" have clearly different connotations. This is also true in the context of liability coverage--one may be said to have anticipated or expected a type of harm to occur without having acted with the purpose of causing the harm.

It is likely that the debate concerning damages attributable to the Y2K problem will center on whether these problems could or should have been anticipated by the insured. The focus therefore likely will center on the word "expected," as used in CGL policies, rather than whether the insured intended to cause the resulting harm. Many courts have long taken the position that the word "expect" should be applied using an objective test. Some courts have equated the term with reasonable foreseeability, finding that if it was reasonably foreseeable that the result would occur, then it was "expected" and therefore not covered./12/

Other cases hold that "expected" denotes that the actor knew or should have known that there was a substantial probability that certain consequences would result from his actions. In City of Carter Lake v. Aetna Casualty & Surety Co., the Eighth Circuit stated:

If the insured knew or should have known that there was a substantial probability that certain results would follow his acts or omissions, then there has not been an occurrence or accident as defined in this type of policy when such results actually come to pass./13/

Some courts, on the other hand, have utilized a subjective standard, holding that the appropriate test for "expected" damage is whether the insured knew or believed its conduct was substantially certain or highly likely to result in the kind of damage that occurred./14/

Whether an objective or subjective test is applied to the word "expected," the question that must be asked in cases involving computer errors caused by the Y2K bug is this: Were the resulting damages truly unknown and unexpected by the insured?

Given the amount of media coverage dedicated to the problem already and the probable increase in attention until the year 2000 arrives, even those who heretofore have been unaware of the problem, or who have turned a deaf ear to pertinent information, will at some point be unable truthfully to claim complete ignorance of the potential risks. They will be hard pressed to argue successfully that the problem could not have been anticipated. This will be particularly true for those organizations that employ personnel responsible for keeping informed of potential risks to the organization. Smaller, less sophisticated organizations and individuals, however, may be more successful in arguing that they were unaware of the Y2K problem at all or were unaware that the problem existed in their own systems.

D. Will Losses Constitute "Bodily Injury" or "Property Damage"?

The requirement that a risk be fortuitous will be only one aspect of the debate issue concerning coverage for Y2K losses. Another important facet will be whether the resulting losses constitute either "bodily injury" or "property damage" under CGL policies.

1. Bodily Injury

Under a standard CGL policy, "bodily injury" is defined as follows: "bodily injury, sickness or disease sustained by a person, including death resulting from any of these at any time."

Many claims made as a result of computer systems not being Y2K-compliant could fall within the definition of "bodily injury," such as claims by those unable to obtain emergency medical care, injuries caused by power failures, and injuries caused by timed medical equipment not operating correctly. Some of these claims might be covered under CGL policies, assuming the fortuity requirement can be met.

For example, if a hospital patient were on a computer-operated dialysis machine that failed as a result of the Y2K bug, it would be difficult for the hospital to claim that the resulting injury was not expected, given the wide dissemination of information regarding potential Y2K problems and the expectation that hospitals would keep abreast of such hazards. If, however, the patient were using a home-operated dialysis machine, the argument that he or his caregiver was not aware of the potential problem might be far more credible.

It is also important to note that claims of emotional distress, without physical injuries, are not covered in most jurisdictions because they are not found to constitute "bodily injury."/15/ Thus, one’s distress about problems resulting from computer errors and failures as a result of the Y2K problem would not be recoverable under CGL policies in most jurisdictions.

2. Property Damage

"Property damage" in a standard CGL policy is defined as:

a. Physical injury to tangible property, including all resulting loss of use of that property. All such loss of use shall be deemed to occur at the time of the physical injury that caused it or
b. Loss of use of tangible property that is not physically injured. All such loss of use shall be deemed to occur at the time of the "occurrence" that caused it.

A two-prong test is used to determine if claims constitute property damage under CGL policies. Under the above definition, coverage may be found if an insured’s acts and/or defective product causes either physical injury to a third party’s tangible property or causes the loss of use of a third party’s tangible property./16/ Tangible property has been defined as "property . . . having physical substance apparent to the senses,"/17/ or as property that is "capable of being handled or touched."/18/

Many of the losses resulting from the Y2K bug no doubt will be economic losses, such as lost profits, loss of good will, nonperformance of contractual obligations, damage to reputation and loss of investment. As an example, if a bank sends out billing statements to its customers incorrectly informing them that they owe millions of dollars in interest on their outstanding debts, and if, as a result, the bank loses customers, profits and good will and then sues its computer or software supplier, should the claim against the supplier be covered?

The answer is no. As a rule, there is no recovery under CGL policies for purely economic losses because they do not constitute physical injury to tangible property./19/ Even if a claim could be deemed a loss of use of tangible property under a CGL policy, there would be no coverage if it results in a purely economic loss./20/ Accordingly, the claim tendered by the computer or software supplier would not be covered.

A similar analysis would apply to consequential damages. Legal authorities generally have found that in looking at whether consequential damages are covered, it must first be determined whether they follow a loss that meets either of the two prongs required for property damage--either a direct physical injury to tangible property or a loss of use of tangible property. If neither of the two prongs is met, then the consequential damages would also not constitute property damage./21/

Thus, if an insured who supplies payroll accounting services to a customer uses a computer system that has the Y2K bug and, as a result, is unable to process payroll checks in January 2000, and if the customer is required to employ additional personnel time to do the payroll manually, those costs would not be covered because they are purely economic losses.

Insurance carriers should be prepared for a host of novel theories that will be advanced in support of finding coverage for Y2K-related claims. One argument that should be anticipated is the claim that inclusion of software having the Y2K bug into a computer system constitutes physical injury to tangible property.

With respect to the first of these arguments, most jurisdictions follow the rule that the mere presence of a defective component in a third party’s product, even if the product as a computer system, does not by itself constitute "property damage" under CGL policies because there is no actual physical injury to or destruction of tangible property./22/ Thus, with respect to the claim that the inclusion of non-Y2K compliant software in a computer system would constitute physical injury to tangible property, if there is no other injury meeting either the definition of property damage or bodily injury under a CGL policy, there would be no coverage.

Some courts on the other hand have found that when a defective component is so intertwined with the completed product that the defect necessarily results in damage to the finished product, then property damage can be found./23/ Even in such a case, however, the fortuity requirement would have to be met and exclusions would be considered to determine if coverage is available.

E. Is Computer Software Tangible Property?

Another likely argument will be that software having the Y2K bug constitutes a loss of use of the software and thus a loss of use of tangible property.

CGL policies, as noted above, will provide coverage for loss of use of tangible property. In order for a loss of use of the software to be covered as property damage, therefore, the software itself would have to be deemed tangible property. This raises the intriguing question of whether software should be deemed tangible property or intangible property.

Although a few cases pertaining to insurance coverage have attempted to address the issue, the contradictory findings have resulted in no definitive answer to the question./24/ For the most part, courts have managed to sidestep this issue as it would apply to insurance coverage by focusing instead on other provisions in the policies to resolve the coverage issues./25/

The issue has been addressed, however, by the courts in tax cases for the purpose of determining whether the investment tax credit authorized by Section 48(a) of the Internal Revenue Code and the accelerated cost recovery system deduction available for tangible property under Section 168(c) should be applied to computer software. The tax cases reach opposite conclusions, some finding that software should be deemed tangible property,/26/ and others finding that it should be considered intangible property./27/ Although the majority viewpoint has been that software should be deemed intangible property for the purposes of the tax laws, it is unclear whether that will remain the position of a majority of courts.

If software is considered intangible property in an insurance context, the loss of use of software infected with the Y2K bug would be loss of use of intangible property and would not constitute property damage under CGL policies.

Even if software is found to be tangible property in the context of insurance coverage, coverage must still be found to have been caused by an occurrence and to escape exclusions.

F. Exclusions for Insured’s Product or Work

Most newer CGL policies, beginning with the 1986 version, include exclusions that are similar to the following:

This insurance does not apply to:


k. Damage to Your Product


"Property damage" to "your product" arising out of it or any part of it.


l. Damage to Your Work


"Property damage" to "your work" arising out of it or any part of it and included in the "products-completed operations hazard."

This exclusion does not apply if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor.

The effect of these exclusions is to preclude coverage for repairing or replacing the insured’s defective product, defective components in the insured’s product or any other part of the insured’s product that may have been damaged by the defective component./28/ The reasoning is that the consequence of creating a faulty product is a risk of doing business, and the insured rather than its insurer should bear the cost of replacement or repair of faulty goods and work./29/ This exclusion also excludes the insured’s own work that is included in the products-completed operations hazard, that is, work for which the insured has completed operations. Furthermore, because "your work" and "your product" are defined by the policies as including warranties or representations regarding the fitness, quality and performance of the insured’s work or product, any liability arising from the insured’s breach of these warranties also would be excluded./30/

In the context of computer software that is not Y2K compliant, if the policyholder supplied the non-compliant software and was sued by a dissatisfied purchaser, the supplier would not be covered for repairing or replacing the software because of the above exclusions. Furthermore, if the policyholder were a party who was retained to make the software Y2K compliant, and if he completed his work but failed to perform the work adequately, there would again be no coverage for the work performed. And if the policyholder were sued for breach of express warranties related to software it supplied or performed operations on, there also would be no coverage.

A claim of property damage based on an insured’s unsuccessful attempt to correct a Y2K problem in another’s system or product could be excluded from coverage by the Exclusion j, which is found in most recent CGL policies and excludes "property damage" to "That particular part of any property that must be restored repaired or replaced because 'your work' was incorrectly performed on it.

By its terms, this exclusion would preclude coverage for computer systems or products that must be restored, repaired or replaced because the policyholder’s work was performed on it, such as an unsuccessful attempt to correct a Y2K problem.

Insurers also should anticipate the claim that the incorporation of software with the Y2K bug into a system or product constitutes a loss of use of tangible property, the tangible property being the system or product. Such a claim may be precluded, however, by the following exclusions found in most recent CGL policies:



m. Damage to Impaired Property or Property Not Physically Injured

"Property damage" to "impaired property" or property that has not been physically injured, arising out of:
(1) A defect, deficiency, inadequacy or dangerous condition in "your product" or "your work"; or
(2) A delay or failure by you or anyone acting on your behalf to perform a contract or agreement in accordance with its terms.

This exclusion does not apply to the loss of use of other property arising out of sudden and accidental physical injury to "your product" or "your work" after it has been put to its intended use.


This exclusion, commonly called the "impaired property" exclusion, is included to prevent the insured from claiming coverage for economic losses resulting from his own work or product./31/ Impaired property is defined in the policies to mean tangible property that cannot be used or is less useful because it either incorporates the insured’s work or product or because the insured failed to fulfill terms of a contract, but the property could be used if the insured’s work or product were repaired or replaced or if the insured fulfilled the contract terms. The exclusion applies if there is no claim of injury to other property, but only economic loss resulting from injury to the product itself. These kinds of design errors in the insured’s products are not covered because they are regarded as the insured’s normal business risk, which liability insurance is not intended to cover./32/

Accordingly, if non-Y2K compliant software supplied by the insured caused an organization’s computer to be inoperable, and if the losses were purely economic losses, there would be no coverage because of the impaired property exclusion. This is in addition, of course, to the fact that economic losses are generally found not to constitute property damage.

Newer CGL policies typically also provide that the following are excluded from coverage:



n. Recall of Products, Work or Impaired Property


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.

This is the "sistership" exclusion, so called because it arose from the recall of a group of airplanes when one of the "sister" ships evidenced a structural defect./33/ The exclusion precludes coverage for the recall of products with similar defects that have not yet failed./34/ The rationale behind the exclusion is to prevent the insurer from being saddled with the cost of preventing other failures./35/

Thus, if an insured supplier markets a product that is not Y2K compliant, only to recall the product because of the defect, there would be no coverage for the cost of the recall.

D&O COVERAGE

If businesses begin failing as a result of computer malfunction or shutting down because of the Y2K bug, it is a safe assumption that those affected will begin pointing the finger of blame at people in management. CGL policies do not as a rule provide coverage for directors and officers in the performance of their duties. Directors and Officers (D&O) coverage, however, may come into play.

D&O policies generally provide two types of coverage for the acts of directors and officers: (1) "directors and officers" liability coverage and (2) "corporate reimbursement" coverage. The first is coverage for the director or officer directly, and the second is coverage for the corporation that has agreed to indemnify its officers or director for their negligent acts./36/ Coverage is not provided under either type of D&O coverage for a corporation’s own liability./37/

D&O policies provide coverage for the "wrongful acts" committed by corporate directors and officers in their capacity as such. A wrongful act is defined in many D&O policies as: "[A]ny breach of duty, error, misstatement, misleading statement, or omission by the insured directors or officers so alleged by any claimant solely by reason of their being directors or officers."

Although the definition of wrongful act is fairly broad, it is tempered by the requirement usually found in the insuring clause that the wrongful acts have been committed by the directors or officers in their respective capacities as such. Most D&O policies, however, exclude coverage for fraudulent, dishonest or criminal acts. Unlike CGL policies, D&O policies also exclude coverage for claims of injury or death and for loss or damage to any tangible property. Thus, coverage for a Y2K claim that would not be provided under a CGL policy because it does not constitute property damage might be found under a D&O policy if the other requirements of the policy are met.

The most common actions against corporate directors and officers are derivative suits brought in the name of the corporation by shareholders alleging mismanagement; actions brought by individual shareholders for their individual losses; actions brought by third parties, such as customers or regulatory agencies; and shareholder suits alleging violations of securities laws for failure to provide accurate, timely and complete information to the public. The most frequent complaint against directors and officers is mismanagement, which would include taking actions based on faulty decisions and the failing to take actions as needed./38/

Violations of the securities laws could arise because publicly held companies in the United States must file a Form 10-K with the Securities and Exchange Commission annually and discuss any material events and uncertainties that could impact the corporation’s financial condition. Presumably this could include disclosures of potential or real Y2K problems. Some D&O policies, however, specifically exclude coverage for losses arising from violations of the securities laws./39/

A director or an officer might be shielded from liability under the so-called business judgment rule, which generally provides that directors or officers may not be liable if the duties were performed in good faith, in a manner they reasonably believed was in the best interest of the corporation, and with the care an ordinarily prudent person in a like position would use in similar circumstances./40/ Even if the facts show that the director or officer ultimately might be exonerated, however, the insurer may still have the duty to defend because the definition of a wrongful act usually includes acts or omissions that are merely alleged.

D&O coverage is written on a claims-made basis, requiring that claims be tendered within the policy period. If the insurer cancels or refuses to renew a policy, however, an "extended reporting period" or "discovery period" may allow the insured, for payment of an additional premium, an extension of coverage for a specified discovery period for any incident which occurs during the policy term or discovery period and which is expected to give rise to a claim if based on a wrongful act committed before the date of cancellation or nonrenewal. Insurers that intend to issue notices of nonrenewals or cancellations of polices should anticipate that the notices likely will prompt many businesses to respond by providing a laundry list of all events that could give rise to a claim being asserted./41/ And this would include information regarding possible claims related to Y2K problems.

Many policies also have extended reporting periods that cover wrongful acts committed during a specific "retroactive date" preceding the inception of the policy period. Under these policies, therefore, if a Y2K-related claim were made during the policy period, it would have to be shown that the organization's officers and/or directors committed a wrongful act during the retroactive period that led to the loss.

Any corporation that has failed to take appropriate actions to remedy a potential Y2K problem before the effects begin to manifest themselves should anticipate all types of claims being brought against its corporate management in view of the fact that many would believe those in management should have been aware of any such problems and should have taken steps to prevent them. Carriers should be prepared for all types of Y2K-related problems that might be deemed wrongful acts under D&O policies if they can be traced to failures by the directors or officers to act appropriately in their duties.



E&O COVERAGE



Errors and omissions (E&O) coverage, also called malpractice insurance, provides coverage to insureds for claims arising from acts, errors or omissions in the performance of certain professional services, such as in the legal, medical, architectural, engineering, insurance and accounting fields. E&O coverage differs from the coverage provided under CGL policies in several critical aspects.

Unlike CGL coverage, E&O coverage usually does not require that damages be caused by an accident as part of the definition of an occurrence, although E&O policies, like CGL policies, also exclude coverage for intentional misconduct. CGL policies, unlike E&O policies, do not cover economic losses that result from malpractice./42/ Like CGL policies, however, E&O policies do not insure claims for breach of contract. Many E&O policies also have specific exclusions for claims based upon bodily injury or property damage, and virtually all of them exclude coverage for dishonest, fraudulent, malicious, or criminal acts, errors or omissions./43/

E&O policies now are generally written on a claims-made basis, while most CGL policies are still issued on an occurrence basis. Thus, claims would have to be both made against the insured and reported to the carrier during the policy period./44/ Some E&O policies that provide only limited coverage may include a condition to the coverage provision stating that insureds had no basis to believe that they had breached a professional duty prior to the policy period or did not know or could not have reasonably foreseen that an act, error or omission would be the basis of a claim./45/ Most E&O policies require that the professional services complained of have taken place subsequent to a "retroactive date" preceding the inception of coverage as a means of limiting the extent of claims covered for prior acts. Accordingly, if the professional services related to a Y2K problem were rendered before the retroactive date, then no coverage would be afforded.

Applicants for E&O policies usually are required to disclose any pending claims against them or any matter they have reason to believe may give rise to a claim. Any existing or potential claims disclosed would be excluded from coverage. Thus, any professional providing services related to resolving a Y2K problem who has reason to believe it could give rise to a future claim would have an obligation to disclose it in an application for malpractice insurance, and if such a claim arose, it would be precluded from coverage. Failure to make disclosures in an application could be grounds for rescission or noncoverage of the claim./46/

Individuals or organizations whose professional responsibilities include providing advice relating to a third party’s computer system could be at risk should the system fail as a result of a Y2K problem. To trigger E&O coverage, however, the damages claimed must be directly related to the individual’s professional services./47/ It is worth noting that many E&O policies issued to accountants specifically exclude from coverage services related to electronic data processing and the sale of hardware and software related to data processing. And unlike CGL coverage, E&O policies generally require the consent of the insured before a third-party claim can be settled.



FIRST-PARTY COVERAGE



First-party insurance covers loss or damage suffered by the insured directly. There are many types of first-party insurance available--for example, life, health, disability, property, automobile, fidelity and surety, credit, mortgage, title. But property insurance probably would be the coverage under which most first-party Y2K claims would be tendered. Property insurance is usually drafted as either a "named-perils" policy, in which the risks to be covered are specifically named,/48/ or as an "all-risk" policy, in which all risks of physical loss are covered except risks specifically described as excluded. An important difference between the two types of property coverage is that with a named-perils policy the insured has the burden of proving that a claim is covered, while under an all-risk policy the insurer has the burden of proving that a claim is excluded./49/

While all-risk policies provide broader coverage than named-perils policies, both require that the insured property be actually damaged or destroyed before the insurer can be found liable. A typical coverage provision (ISO Form CP 00 10 10 91) states: "We will pay for direct physical loss of or damage to covered property at the premises described in the declarations caused by or resulting from any covered cause of loss."

If the basis of the property loss is the failure of embedded, non-Y2K compliant software, there will be the same difficulties in finding "physical loss of or damage" to the property as in finding physical injury to tangible property under a CGL policy. Without a finding of physical loss or damage, property insurance will not provide coverage for Y2K claims.



A. Fortuity Requirement

The requirement that a loss be "fortuitous" in order for insurance to apply is not a concept confined to third-party insurance; it applies to first-party insurance as well. While property insurance policies do not generally articulate this concept in either the coverage provisions or in the lists of exclusions, the fortuity requirement is nevertheless considered essential to determining whether any loss is covered./50/

A property insurer, like a liability insurer, will not be held liable for damages that are known or are apparent before a policy takes effect, because they are not unknown or contingent risks./51/ "Risks" or "perils" in a property insurance policy are said to refer to fortuitous, active and physical forces, such as lightning, wind and explosion which bring about the loss./52/

Furthermore, latent pre-existing defects that make the occurrence of a loss inevitable at the time the insurance is procured also have traditionally been deemed uninsurable. For example, a crack in a boiler on a vessel that developed as a part of the manufacturing process before the inception of the policy has been found to be not covered,/53/ and damage to shower stalls that had been constructed without shower pans were not covered because the loss was found to be inevitable, not fortuitous./54/

Some more modern decisions, however, have used a more flexible approach, permitting coverage when the inevitability of a loss was not known to the parties at the time the contract of insurance was made./55/ Whether a loss was known or apparent at the time the contract of insurance was made is a question of fact in each case./56/

The "manifestation of damage" rule provides that only the insurer on the risk at the time a loss is initially manifested is responsible for the loss unless the loss is specifically excluded under the terms of the policy. Manifestation of a loss occurs when "appreciable damage occurs and is or should be known to the insured," and insurers whose policies begin after the initial manifestation of loss are not liable for any previously discovered and manifested loss./57/

This rule is most often used in cases in which a loss has been progressing over a period of time, and involves more than one policy. Under this rule, there is no duty to cover potential losses that have not yet occurred or to pay for investigating potential losses./58/

In the context of Y2K losses, if it can be shown that it was a known or apparent risk when the policy was written that a computer system or product would fail in the year 2000 as a result of the Y2K bug, the fortuity requirement should preclude coverage. If the latent defect rationale were to be applied to losses caused by computer systems or products developed with the Y2K bug, then an insurer whose policy was in effect at the time the software was installed should not be found liable if there was no manifestation of damage at the time. If the manifestation rule is followed, even if an organization were aware before the year 2000 of the existence of the Y2K bug, its insurer would not be liable if there has been no actual manifestation of damage, which likely would not occur until the year 2000.

Although some courts have loosened the fortuity requirement somewhat in the context of property insurance, claimants must still overcome the hurdle of the "latent defect" and "inherent vice" exclusions. In more recent policies--for instance, ISO Form CP 10 20 10 91--these exclusions have been combined: "We will not pay for loss or damage caused by or resulting from: . . . Rust, corrosion, fungus, decay, deterioration, hidden or latent defect or any quality in property that causes it to damage or destroy itself." (Emphasis supplied.)

The fortuity concept is at the heart of the latent defect and inherent vice exclusions, precluding coverage for a property loss when the damage is a certainty because of an inherent cause./59/ Under these exclusions, a latent defect is generally defined as one "that could not be determined by any known or customary test,"/60/ while an "inherent vice" generally indicates a loss brought about entirely by some quality within the property which leads to its own destruction./61/ These exclusions would preclude coverage for any kind of latent defect, whether the result of design or of faulty construction.

The inability of non-compliant software to distinguish between the years 1900 and 2000 could be found to be a latent defect and/or an inherent vice in the computer system or product. Thus, strict enforcement of the latent defect/inherent vice exclusions should exclude coverage for resulting Y2K claims.



B. Business Interruption

A property insurance policy will not, as a rule, insure profits lost during a period of reconstruction or repair of damaged property. As a result, many businesses choose to purchase additional coverage, which is called business interruption insurance or loss of income insurance. It covers the earnings that an insured would have realized if not for the interruption of its business by an insured peril and for continuing expenses during the period of repair or restoration of the property damaged./62/ The rationale is that an insured may not be made whole by mere compensation for its physical loss caused by the insured peril./63/

A typical business interruption coverage provision is:

[T]his policy covers only against loss resulting directly from necessary interruption of business conducted by/or through the insureds’ . . . operations caused by damage to or destruction of any of the real or personal property . . . hereinafter described . . . by the perils insured against by the terms of this policy which . . . results directly in the necessary interruption of the insureds’ business.

The Company shall be liable for the ACTUAL LOSS SUSTAINED by the Insured resulting directly from such interruption of business, but not exceeding the reduction of Gross Earnings less charges and expenses which do not necessarily continue during the interruption of business, for only such time as would be required with the exercise of due diligence and dispatch to rebuild, repair or replace such . . . properties as has been damaged or destroyed commencing with the dates of such interruption of the Insured’s business and not limited by the expiration date of this policy./64/

Business interruption coverage usually requires the insured to take necessary steps to commence business operations as soon after the loss as possible,/65/ including using other available sources./66/ In many policies this may be a condition precedent to recovery. If a loss meets the terms of the policy, coverage may extend for a reasonable period required to effect repairs,/67/ and the reasonable period would be a question for a jury./68/

An insured who has been forced to suspend operations of its business as a result of the malfunctioning of its non-Y2K compliant computers or products could attempt to recover under its business interruption policy for the profits it would have earned had the interruption not occurred, but there are several hurdles. First, a physical loss to property is almost always required by the terms of the policy. In the case of a computer or product malfunctioning because of non-compliant software, it is questionable whether this can be met. Second, there would have to be a showing that the loss was caused by the happening of a covered peril. In the case of a named-perils policy, this would be the insured’s burden of proof. Third, the insured would have to show an actual loss sustained pursuant to the definition provided by the policy. And, as with all insurance claims, the fortuity requirement must be met with a showing that the failure of the computer system or software could not have been anticipated.



AFFIRMATIVE COVERAGE

A few major American insurers (AIG, for example) have begun offering coverage for the Y2K problem. It is quite expensive and requires large limits, and it probably will appeal only to large corporations.

The coverage is expensive because the insurer may keep the premium for only a few months since the damage may occur right after the year 2000 arrives, and the insurer will have received the premium only several months before. For example, for a $100 million policy limit, the insurer may charge an $80 million premium, agreeing to refund to the insured the $80 million (less 10 percent to the insurer) at the end of the policy term if no losses have occurred. This provides the insured a strong incentive to avoid claims, including taking remedial steps to reduce exposure. The cost to the insured is $8 million (10 percent), plus the loss of use of the $80 million for the policy term.

This coverage is only in the beginning stages, and it will be interesting to track its popularity.



CONCLUSION

The Y2K bug and the plethora of related problems likely to arise on January 1, 2000, are not simply overblown media hype. Even if many businesses and organizations manage to invest the time and funds to make their computer systems Y2K compliant before the year 2000, many others will fail to do so or will be unable to do so because of the shortage of qualified computer specialists. Because of the complex interrelationships shared in the global society, no one entity or person will be immune from the effects of the Y2K bug, and the result could be a staggering breakdown of vital institutions worldwide.

Although there no doubt will be a swarm of claims made as a result of the Y2K bug, many claims will not be covered. Claims made against software and computer suppliers may be precluded from coverage because of policy exclusions. Coverage also may be denied in cases in which the fortuity requirement is not met or because the claims do not meet the definition of an "occurrence" under CGL policies.

Both insureds and insurers will need to evaluate their policies and the claims made closely to determine if coverage is in fact afforded.



FOOTNOTES

1. California Assemblyman Brooks Firestone, R-Santa Barbara, quoted in the San Francisco Daily Journal, April 17, 1998, page 1.

2. Manny Fernandez, CEO Gartner Group, interviewed on Cable News Network, "Digital Jam," May 27, 1998; Business Wire Inc., "Year 2000 Wire/NovaQuest InfoSystems Signs on ss WRQ Year 2000 Express Expert," May 18, 1998 (estimate of Gartner Group).

3. Ann Coffou, Managing Director, Giga Year 2000 Relevance Service, quoted by R. Nutting, TechWire, March 20, 1997.

4. See generally 7A APPLEMAN, INSURANCE LAW AND PRACTICE §§ 4493, 4521 (1979 & Suppl.)

5. See, e.g., Stanford Ranch Inc. v. Maryland Cas. Co., 89 F.3d 618, 624-25 (9th Cir. 1996) (applying California law); Ins. Co. of the West v. Haralambos Beverage Co., 241 Cal.Rptr. 427, 430 (Cal.App. 1987); Fireman’s Fund Ins. Co. v. City of Turlock, 216 Cal.Rptr. 796, 800 (Cal.App. 1985).

6. Haralambos, 241 Cal.Rptr. at 430-31. See also Allstate Ins. Co. v. Hansten, 765 F.Supp. 614 (N.D.Cal. 1991) (discussing difference between contract and tort liability).

7. See, e.g., Loyola Marymount Univ. v. Hartford Accident & Indem. Co., 271 Cal.Rptr. 528, 533 (Cal.App. 1990).

8. See, e.g., Bartholomew v. Appalachian Ins. Co., 655 F.2d 27, 29 (1st Cir. 1981) ("The concept of insurance is that the parties, in effect, wager against the occurrence or nonoccurrence of a specified event; the carrier insures a risk, not a certainty.")

9. PATTERSON, ESSENTIALS OF INSURANCE LAW § 58 (2d ed. 1957).

10. See, e.g., Montrose Chemical Corp. of California v. Admiral Ins. Co., 913 P.2d 878 (Cal. 1995); Prudential-LMI Commercial Ins. v. Superior Court (Lundberg), 798 P.2d 1230 (Cal. 1990).

11. No. C-3956-85, slip op. at 18 (N.J.Super. Ch. Div., Aug. 27, 1987), aff’d on appeal, rev’d on cross-appeal, 629 A.2d 895 (App.Div. 1991), aff’d, 629 A.2d 831 (N.J. 1993), cert. denied, 512 U.S. 1245 (1994).

12. See, e.g., City of Aurora v. Trinity Universal Ins. Co., 326 F.2d 905 (10th Cir. 1964); Gassaway v. Travelers Ins. Co., 439 S.W.2d 605 (Tenn. 1969); Town of Tieton v. General Ins. Co., 380 P.2d 127 (Wash. 1963).

13. 604 F.2d 1052, 1059 (8th Cir. 1979).

14. See, e.g., Shell Oil Co. v. Winterthur Swiss Ins. Co., 15 Cal.Rptr.2d 815 (Cal.App. 1993).

15. See B. OSTRAGER & T. NEWMAN, HANDBOOK ON INSURANCE COVERAGE DISPUTES 303-310 (9th ed. 1998) (providing survey of states on issue of whether emotional distress constitutes bodily injury).

16. See, e.g., Maryland Cas. Co. v. Reeder, 270 Cal.Rptr. 719, 723 (Cal.App. 1990).

17. Warner v. Fire Ins. Exch., 251 Cal.Rptr. 635 (Cal.App. 1995). See also Gunderson v. Fire Ins. Exch., 44 Cal.Rptr.2d 272 (Cal.App.1995).

18. See, e.g., Lay v. Aetna Ins. Co., 599 S.W.2d 684, 686 (Tex.Civ.App. 1980).

19. See, e.g., Waller v. Truck Ins. Exch., 900 P.2d 619 (Cal. 1995); Travelers Ins. Cos. v. Penda Corp., 974 F.2d 823, 829 (7th Cir. 1992); Sentry Ins. Co. v. S&L Home Heating Co., 414 N.E.2d 1218, 1221 (Ill.App. 1980) (economic loss includes loss of productivity and is not property damage); Am. States Ins. Co. v. Hurd Bros. Inc., 509 P.2d 1015, 1017 (Wash.App. 1973) (loss of storage charges not covered because not tangible property); Lowenstein Dyes & Cosmetics Inc. v. Aetna Life & Cas. Co., 524 F.Supp. 574, 577 (E.D. N.Y. 1981), aff’d, 742 F.2d 1437 (2d Cir. 1983) (business losses not tangible property).

20. See, e.g., Penda Corp., 974 F.2d at 829 (allegations of lost future profits and damage to reputation arising from loss of use of lithograde styrene sheets were purely economic losses and not covered).

21. See OSTRAGER & NEWMAN, supra note 15, at § 7.03[b], citing Federated Mut. Ins. Co. v. Concrete Units Inc., 363 N.W.2d 751, 757 (Minn. 1985); Sting Sec. Inc. v. First Mercury Syndicate Inc., 791 F.Supp. 555, 562 (D. Md. 1992); Aetna Cas. & Sur. Co. v. First Sec. Bank, 662 F.Supp. 1126, 1130 (D. Mont. 1987); Yakima Cement Prods. Co. v. Great Am. Ins. Co., 608 P.2d 254, 259 (Wash. 1980).

22. See, e.g., Hamilton Die Cast Inc. v. United States Fidelity & Guar. Co., 508 F.2d 417, 419 (7th Cir. 1975); Maryland Cas. Co. v. Reeder, 270 Cal.Rptr. 719, 723 (Cal.App. 1990); Elco Indus. Inc. v. Liberty Mut. Ins. Co., 414 N.E.2d 41, 47 (Ill.App. 1980); Seagate Tech. Inc. v. St. Paul Fire & Marine Inc. Co., 11 F.Supp.2d 1150 (N.D. Cal. 1998) (incorporation of defective, but not inherently dangerous, disk drive into computer not property damage); Schaefer/Karpf Productions v. CNA Ins. Cos., 76 Cal.Rptr.2d 42 (Cal.App. 1998) (incorporation of defective or harmful videotapes into another product not property damage).

23. See, e.g., Pittway Corp. v. Am. Motorists Ins. Co., 370 N.E.2d 1271, 1274 (Ill.App. 1977); Goodyear Rubber & Supply Co. v. Great Am. Ins. Co., 471 F.2d 1343, 1344 (9th Cir. 1973).

24. See, e.g., St. Paul Fire & Marine Ins. Co. v. Nat'l Computer Systems Inc., 490 N.W.2d 626 (Minn.App. 1992) (computer data are intangible property); Retail Systems Inc. v. CNA Ins. Cos., 469 N.W.2d 735, 738 (Minn.App. 1991) (same). See generally Brady, Lost or Damaged Computer Data: "Property Damage" or Intangible Information under a Commercial Liability Policy?, 46 FICC QTRY. 101 (1995).

25. See, e.g., Centennial Ins. Co. v. Applied Health Care Sys., 710 F.2d 1288 (7th Cir. 1983); Magnetic Data v. St. Paul Fire & Marine Ins. Co., 442 N.W.2d 153, 156 (Minn. 1989).

26. See, e.g., Norwest Corp. v. Comm'r, 108 T.C. 358 (1997); Comshare Inc. v. United States, 27 F.3d 1142 (6th Cir. 1994); Texas Instruments Inc. v. United States, 551 F.2d 599 (5th Cir. 1977)

27. See, e.g., Ronnen v. Comm'r, 90 T.C. 74 (1988), amended, slip op. (T.C. 1988); District of Columbia v. Universal Computer Assocs. Inc., 465 F.2d 615 (D.C. Cir. 1972).

28. See, e.g., Fresard v. Michigan Millers Mut. Ins. Co., 327 N.W.2d 286, 292 (Mich. 1982). See also Geddes & Smith Inc. v. St. Paul Mercury Indem. Co., 334 P.2d 881, 885 (Cal. 1959); Armstrong World Indus. Inc. v. Aetna Cas. & Sur. Co., 52 Cal.Rptr. 690, 746 (Cal.App. 1996); Western Employers Ins. Co. v. Arciero & Sons Inc., 194 Cal.Rptr. 688, 690 (Cal.App. 1983).

29. See Oscar W. Larson Co. v. United Capitol Ins. Co., 845 F.Supp. 445, 450 (W.D. Mich. 1993), summ. judgment granted in part, 845 F.Supp. 451 (W.D. Mich. 1993).

30. See Action Auto Stores Inc. v. United Capital Ins. Co., 845 F.Supp. 428, 440-41 (W.D. Mich. 1993), summ. judgment granted in part, 845 F.Supp. 428 (W.D. Mich. 1993).

31. See Transcon. Ins. v. Ice Systems of America, 847 F.Supp.947, 950 (M.D. Fla. 1994) (losses resulting from cancellation of hockey game caused by insured supplying defective ice rink were purely economic and excluded).

32. See Am. Employers’ Ins. Co. v. Maryland Cas. Co., 509 F.2d 128, 130 (1st Cir. 1975); Armstrong World Indus., 52 Cal.Rptr. at 747.

33. See Action Auto Stores, 845 F.Supp. at 426.

34. See Todd Shipyards Corp. v. Turbine Serv. Inc., 674 F.2d 401, 419 (5th Cir. 1982); Arcos Corp. v. Am. Mut. Liab. Ins. Co., 350 F.Supp. 380, 384 n.2 (E.D. Pa. 1972).

35. Action Auto Stores, 845 F.Supp. at 426, citing Honeycomb Sys. Inc. v. Admiral Ins. Co., 567 F.Supp. 1400, 1406 (D. Me. 1983).

36. See generally 4 CALIFORNIA INSURANCE LAW §§ 43.02[1], 43.02[2], 43.08[10] (Matthew Bender, 1998).

37. See generally 1 BUSINESS INSURANCE LAW AND PRACTICE GUIDE §§ 3.04[1], 3.04[3][b] (Matthew Bender, 1991).

38. Id. at §§ 3.02[1]-[2], [4].

39. See generally OSTRAGER & NEWMAN, supra note 15, at § 20.02[e], citing Alfin Inc. v. Pacific Ins. Co., 735 F.Supp. 115, 117 (S.D. N.Y. 1990); Bendis v. Federal Ins. Co., No. 89-2035-S (D. Kan. Dec. 4, 1989), 1989 U.S. Dist. LEXIS 15930, aff’d, 958 F.2d 960 (10th Cir. 1991).

40. CALIFORNIA BUSINESS INSURANCE LAW AND GUIDE, supra note 37, at § 3.03[2].

41. Id. at § 3.04[2][a].

42. See, e.g., Allstate Ins. Co. v. Interbank Fin. Servs., 264 Cal.Rptr. 25, 27 (Cal.App. 1989).

43. CALIFORNIA INSURANCE LAW, supra note 36, at §§ 46.11[5], 46.11 [2][a].

44. See, e.g., Pacific Employers Ins. Co. v. Superior Court (Rau