Direct Physical Loss in All-Risk Policies: The Modern Trend Does Not Require Specific Physical Damage, Alteration

All-risk policies insure fortuitous losses that are not excluded by the policy. The use of the phrase “all-risk,” however, is somewhat of a misnomer because the policy itself contains numerous specific exclusions. In that regard, “all risks” does not mean “every risk.”

A question arises as to what direct physical loss means against the backdrop of such a broad-based coverage. The modern interpretive trend is liberalizing the meaning of direct physical loss to focus upon loss of use as opposed to direct physical loss involving physical alteration.

“Physical damage,” in ordinary parlance has a widely accepted definition. It means “a distinct, demonstrable, and physical alteration” of its structure or appearance. Port Authority of New York and New Jersey v. Affiliated FM, 311 F.3d 226 (3rd Cir. 2002).

Fire, water, smoke and impact from another object are typical examples of physical damage from an outside source that may demonstrably alter the components of a building and trigger coverage. However, proof of physical damage to a building as an entity by sources unnoticeable to the naked eye may need to meet a higher threshold.

Higher Threshold

The court in Port Authority of New York and New Jersey v. Affiliated FM, observed that physical damage to a building as an entity by sources unnoticeable to the naked eye was required to meet a higher threshold. The court cited to the Colorado Supreme Court in Western Fire Ins. Co. v. First Presbyterian Church, 165 Colo. 34, 437 P.2d 52 (Colo. 1968), where the court concluded that “coverage was triggered when authorities ordered a building closed after gasoline fumes seeped into a building structure and made its use unsafe. Although neither the building nor its elements were demonstrably altered, its function was eliminated.”

Relying upon the Colorado Supreme Court in Western Fire, the court in Port Authority found that the insurance policy not only covers physical damage, but also “physical loss.” Thus, when there was the “presence of large quantities of asbestos in the air of a building, such that the presence of the asbestos in the air made the structure uninhabitable and unusable, then there [was] a direct loss to [the] owner.”

However, in those situations where the asbestos was not in a form or quantity to make the building unusable, the owner would not suffer a covered loss because the structure continued to function and it had not lost its utility. Thus, according to the Port Authority Court, it is appropriate to consider in the coverage analysis whether the presence of a contaminant or substance which does not cause direct physical damage can still constitute a property loss if the contaminant/substance renders the building uninhabitable and unusable.

The analysis will focus on the quantity of the offending item because that item must reach a significant level to warrant coverage, i.e., such quantity to make it comparable to a direct loss like fire, water or smoke on the structure’s use and function.

Anything less would create a standard requiring compensation for repairs caused by the inevitable deterioration of materials used in the construction of the building. That type of result would not comport with the intent of a first party all-risk policy and would transform the policy into a maintenance contract.

Under the analytic construct of Port Authority, “physical loss or damage” occurs only if:

Absence of Structural Damage

The court in Murray v. State Farm, 203 W.Va. 477, 509 S.E.2d 1 (W. Va. 1998) found that direct physical loss may exist if the property is injured with an absence of structural damage as opposed to destroyed. In Murray, the policyholder’s home was damaged by rocks falling from a high wall of a 40-year-old abandoned rock quarry situated next to the home. The insurance company denied coverage arguing the policy excluded losses caused by “landslides” or “erosion.” The home was not damaged by the rocks. However, firemen who responded to the loss compelled the insured to leave the home because additional rocks could fall, and an engineer who later examined the high wall concluded that further rock falls would continue, some potentially producing disastrous results.

The Supreme Court of West Virginia addressed whether covered losses could exist in the absence of structural damage. The court in Murray held that because the home became unsafe for habitation, it suffered real damage when it became clear that rocks and boulder could come crashing down. The court also found that a covered loss included situations that rendered the insured property unsafe or uninhabitable that may exist in the absence of structural damage to the insured property.

In American Guar. & Liab. Ins. v. Ingram Micro, 2000 WL 726789 (D. Ariz. 2000), the court found that physical damage is not restricted to the physical destruction or harm of computer circuitry, but included loss of access, use and functionality. In a technological age, the definition of physical damage when it comes to cyber issues must be more expansive. This creates an inherent tension between the concepts of traditional physical damage and loss of use of functionality. According to the Ingram Micro court, when the computer data was unavailable, the interruption of services would constitute damage or where the computer software or network was altered in some form. Ingram Micro court’s holding was broad regarding the business interruption loss because the data was restored upon being reloaded.

Similarly, the court in Farmers Ins. Co. of Oregon v. Trutanich, 123 Or.App. 6, 858 P.2d 1332 (Or. App. 1993), used a broad and expansive analysis of physical damage.

In Trutanich, the claim involved a house with methamphetamine ordor. The court found persuasive that the persistence of the odor itself was physical. As to the second argument that even if the odor was physical, the defendant was not entitled to recover the cost of removing it. The court found that the property was physically damaged. The cost of removing the odor was a direct rectification of the problem. Removal cost was a direct physical loss itself.

The modern trend signals that courts are not looking for physical alteration, but for loss of use. This is the trend of where the law is going.