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"Physical Damage" in the First-Party Property Policy—A New Definition Coming?

September 2000

Does "physical damage" now include "loss of use and functionality"? A recent federal court ruled that it does. In this surprise ruling, the court held that a business interruption loss was covered despite the fact that the problem computers were not physically damaged—they just would not function properly. Read about the decision and learn how this ruling could give new meaning to all aspects of property insurance forms.

by Doug Berry
Butler Pappas

Recently, a federal court in Tucson reviewed the definition of "physical damage" as the trigger of coverage in a first-party policy and rejected as "archaic" the traditional definitions that would require physical harm to the insured property. This article addresses that decision.

The Ingram Case

In American Guarantee & Liability Ins. Co. v Ingram Micro, Inc., 2000 U.S. Dist. LEXIS 7209 (DC Ariz April 18, 2000), the district court considered the defendant's claim for business and service interruption following a power outage due to a ground fault in the fire alarm panel at its Tucson Data Center. Ingram is a wholesale distributor of microcomputer products, utilizing a worldwide computer network to track its customers, products, and daily transactions, primarily from the Tucson facility. While electrical service to the building was not interrupted, all of the electronic equipment—including computers and telephones—ceased working.

Most of Ingram's equipment was functional when, or soon after, power was restored. However, three mainframe computers lost all the programming information stored in their random access memories and 1.5 hours were required for the programming to be reloaded by Ingram employees. Restoration of the mainframes, however, did not restore connections between Tucson and six other centers in the United States and Europe.

After 8 hours' additional work, the remainder of the network was restored by bypassing a malfunctioning matrix switch. Upon investigation, Ingram determined that when power was restored to the matrix switch, the switch's custom configurations entered before the outage were lost and the default settings had to be reprogrammed to the custom configurations before the proper network could be restored.

Following denial of Ingram's claim for business and service interruption, the insurer filed a declaratory action on the issue of whether the power outage caused "direct physical loss or damage from any cause, howsoever or wherever occurring." American Guarantee submitted two expert affidavits admitting that Ingram's mainframe and matrix switch did not function as before and that additional data entry and reconfiguration were required to provide pre-loss functionality. The affidavits also attested to the fact that the mainframes and switch were not "physically damaged" because their capability to perform their intended functions remained intact.

Following cross-motions for summary judgment on the issue, the court rejected the insurer's traditional definition of "physical damage" and accepted Ingram's "broader definition" which included "loss of use and functionality."

In support of its conclusion, the court did not cite any case law. Rather, after noting that we live in a time "when computer technology dominates our professional as well as personal lives," it relied on the definitions of "damage" found in various federal and state computer crime statutes, such as 18 U.S.C. § 1030 (West 1999). That statute defines "damage" as "any impairment to the integrity or availability of data, a program, a system, or information." Similarly, Missouri defines damage to a computer as "any alteration, deletion, or destruction of any part of a computer system or network." [Mo. Ann. Stat. § 569.093 (West 1999).]

The court was cognizant of the fact the foregoing definitions originate in penal statutes and not in insurance case law. However, since various legislatures have termed interruption of a computer's services "damage," it opined that it would be "archaic" to limit the policy definition to the language advanced by the insurer. The court also considered and discussed Seagate Technology, Inc. v St. Paul Fire & Marine Ins. Co., 11 F Supp 2d 1150 (ND Cal 1998); however, it found the allegations in that case and the instant case distinguishable and declined to apply it.

That Seagate Technology was not useful to the court is not surprising. It appeared relevant at the outset because it discusses "property damage" in the context of incorporation of defective disk drives manufactured by Seagate into personal computers manufactured and sold by another company (which was the plaintiff in a lawsuit against Seagate). However, the decision dealt with the insurer's duty to defend Seagate in that lawsuit under a liability policy. It was not addressing a first-party property insurance policy as was at issue in Ingram.

The Possible Effect of Ingram

Even policy forms that provide coverage for damage to software, even if due to "electrical disturbance," require physical damage (see, e.g., AAIS EDP forms 7200 and 7201). Certainly, if a "loss of use and functionality" constitutes "physical damage," new meaning will be given to virtually all aspects of the customary property insurance forms such as, like here, business interruption, the data processing coverage forms and sue and labor coverages. Should the decision ultimately be affirmed and/or the court's expansive definition of "property damage" be adopted elsewhere, both insurers and insureds could be on the edge of a major revolution in the adjustment, underwriting, and administration of property insurance programs.

Interlocutory review pursuant to 28 U.S.C. 1292(b) was requested but was denied by the Ninth Circuit Court of Appeals. A scheduling conference will be held shortly to set a trial date. Risk managers and insurers should be alert for future references to this decision in any number of contexts. However, at the moment, in the absence of substantive appellate review, the decision is of limited direct, precedential value outside of the Federal Court for Arizona. It could be, however, persuasive authority for any court looking for a basis on which to expand the commonly accepted definition of "property damage."

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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