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What Constitutes ‘Physical Loss’ for Property Insurance?

Insurance Law360
April 4, 2016

By Kristin Suga Heres
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In determining whether a property insurance policy responds to a loss, the fundamental, threshold question to be answered is whether or not the policyholder sustained “physical loss or damage” to insured property. In the absence of “physical loss or damage,” property insurance does not respond.

In the context of claims where a policyholder alleges loss or damage to food or beverage products, the question of whether the product has sustained “direct physical loss or damage” can be particularly thorny. Food and beverage manufacturers facing economic losses arising out of the “loss” of products have strong incentives to argue that something less than actual, physical, present direct physical loss or damage triggers coverage. For instance, some manufacturers have argued that the inability to distribute or sell products, even for reasons not arising out of any physical loss or destruction, constitutes qualifying loss or damage. Others have argued that the potential for future physical loss or damage triggers property coverage. A key problem with these arguments, however, is that they seek to read the word “physical” right out of policies.

In recent years, several courts construing liability policies have declined to find coverage in cases involving food products and other products intended for human consumption where physical loss, damage, or injury was not present. Just this month, Wisconsin’s highest court determined that the incorporation of the incorrect species of bacteria into probiotic supplement tablets did not constitute “physical injury to tangible property” or “property damage” caused by an “occurrence.[1] Similarly, a federal court sitting in California held that there was no “physical injury to tangible property” triggering coverage under a liability policy where cans of tomatoes were pulled from distribution because of a “‘risk’ that they would develop problems” at some point in the future.[2]

While these cases addressed the “physical” loss or damage in the context of liability coverage, a recent Massachusetts case suggests that the same analysis applies in the property insurance context. In HP Hood LLC v. Allianz Global Risks US Insurance Company, a three-judge panel of the Massachusetts Appeals Court affirmed summary judgment in favor of a property insurer, holding that Hood’s policy excluded coverage for a claimed loss of 1.8 million bottles of Myoplex, a dairy-based, aseptically-packaged beverage product formulated and bottled by Hood.[3] In January of this year, the Commonwealth’s Supreme Judicial Court declined to grant Hood’s request for further appellate review, and the Hood case now stands as one of a small number of decisions across the country that have addressed the availability of property insurance coverage for product-related quality issues in the context of food and beverage manufacturing.

In Hood, the policyholder sought coverage under a property insurance policy for claimed product losses arising out of a Myoplex packaging run that did not go as planned. Two days into the May 2009 run, Hood observed that a bottle that had been filled and sealed by its sophisticated “smart” filler machine failed a “secure seal test.” Hood used the elective “SST,” a destructive test performed by puncturing and pressurizing tested bottles, as a means of predicting whether the bottles’ hermetic seals might fail at some point in the future upon being exposed to the rigors of commerce. Concluding that the SST failure was isolated, Hood allowed the run to continue. Later in the run, Hood experienced additional SST failures and subsequently halted production. After conducting additional testing, which yielded additional SST failures, Hood determined that it could not identify through nondestructive means which bottles, if tested, would fail SSTs. Together with its business partner, with whom Hood had contracted to formulate and package the Myoplex, Hood determined that all 1.8 million bottles packaged during the May run were unsalable. Hood later destroyed the entire run.

After an extensive, months-long investigation, Hood concluded that the cause of the SST failures was a defect in the bottles’ caps, which had been purchased from a third-party supplier. The cap defect involved the degradation of lubricant in the caps’ lining over time which affected the amount of torque needed to apply the caps. A small number of caps were applied with an amount of torque insufficient to achieve a hermetic seal that would withstand the pressure applied during SST testing.

Notably, the SST was not part of Hood’s U.S. Food and Drug Administration-mandated testing protocol and was not recognized by authorities as a criterion for determining whether the bottles’ hermetic seals were intact for purposes of releasing them for sale. In fact, every Myoplex bottle that was tested passed FDA-mandated seal integrity tests, and Hood’s own process authority (its liaison with the FDA) concluded that the Myoplex packaged during the May 2009 run could have been released to normal distribution. Further, post-packaging testing and visual inspections revealed that the Myoplex liquid had been formulated properly and did not become contaminated. Nevertheless, Hood made a business decision not to sell the output from the ill-fated run.

The policy at issue in Hood provided coverage for “all risks of direct physical loss or damage” to insured property “provided that such physical loss or damage occurs during the policy period.” In the context of cross-motions for summary judgment, Allianz argued that Hood had not satisfied its threshold burden to establish coverage under the policy because nothing “happened” to the Myoplex; that is, the insured property at issue had not been worked upon by any external force that altered the condition of the property. To the contrary, the Myoplex had rolled off the bottling line in a defective condition and did not change. Moreover, neither the Myoplex liquid nor its packaging had been harmed in any way. Further, Allianz argued that, at most, Hood alleged only the unrealized potential that at some point in the future, the bottles’ hermetic seals might have failed when released to commerce. Allianz argued that the risk of a potential future loss did not satisfy the policy’s requirement of actual, direct physical loss or damage. For its part, Hood urged that, particularly in the context of claimed food and/or beverage product losses, something short of actual physical loss or damage, including the “unsaleability” of a product, was sufficient to trigger coverage.

While the Superior Court effectively rejected the notion that “unsaleability” constituted “direct physical loss or damage,” the court concluded that the risk that the bottles’ seals may have failed in the future was sufficient to give rise to coverage in the first instance. In so holding, the court, adopting Hood’s interpretation of the policy’s “all risk” language, reasoned that since the policy covered “all risks of physical loss or damage,” the risk of potential future damage came within the policy’s coverage.

Although the Appeals Court did not decide the issue of whether Hood had established “direct physical loss or damage” under the policy, the panel very clearly rejected the notion that so-called “all risks” policies cover all losses, including those where there is no actual physical loss or damage:

Hood additionally argues that the policy was intended to cover increased risk of future physical loss or damage, not merely actual physical loss or damage that occurs within the policy period. That argument, which the motion judge seems to have accepted, is at odds with the [policy] language ... The reference in that language to “all risks” being covered does not change that conclusion, because in this context the reference signifies that the policy was intended to cover property damage whatever its cause (subject to exclusion).[4]

The Appeals Court is not alone in suggesting that “all risks” language does not dispense with the requirement that an insured establish “direct physical loss or damage” within the policy period. Another court applying Massachusetts law concluded that “[i]t is impossible to read the [‘all risks’] insurance policy as providing coverage for ‘risk’ in the absence of a ‘damage.”’[5] Together, Hood and Tocci demonstrate that so-called “all risk” policies do not cover mere unrealized “risks in the air.” Instead, they cover actual, physical damage that comes to fruition during the policy period.

Hood is a significant decision for a number of reasons, including its observations with respect to what constitutes physical loss or damage in the food and beverage context. Given the paucity of case law addressing fundamental coverage issues in the context of claimed food and beverage product losses, it is likely that Hood’s impact will be felt in jurisdictions across the country.

—By Kristin Suga Heres, Zelle LLP

DISCLAIMER: Heres represented Allianz Global Risks U.S. Insurance Co. in Hood LLP v. Allianz Global.

Kristin Suga Heres is counsel in Zelle's Boston office.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Wisconsin Pharmacal Co. LLC v. Nebraska Cultures of California Inc., Nos. 2013AP613, 2013AP687, (Wis. Mar. 1, 2016).

[2] Silgan Containers LLC v. National Union Fire Insurance Co. of Pittsburgh, P.A., No. C 09-5971 RS, (N.D. Cal. Oct. 3, 2011), reversed and remanded on other grounds, 543 Fed. Appx. 635 (9th Cir. Oct. 22, 2013).

[3] 39 N.E.3d 769 (Mass. App. Ct. 2015).

[4] Hood, 39 N.E.3d at 772 n.2.

[5] Tocci Bldg. Corp. v. Zurich Am. Ins. Co., 659 F. Supp. 2d 251, 259 (D. Mass. 2009).

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