November 11, 1998

Open Letter from the Directors of RRC Addressing Recent Questions about Y2K

Client companies have asked members of RRC for an interpretation of catastrophe cover under various Y2K circumstances. RRC wishes to address these requests in this open letter, which we hope will satisfy questions or identify assumptions requiring further client/reinsurer discussion. The observations that follow are driven by widely accepted reinsurance principles applicable to all catastrophe treaties. One of these principles is utmost good faith. Another is the principle of proximate cause - a definition of "any one event," (which definition must itself meet the standards of broad market practice) that includes only insured loss directly resulting from a single event. In addition to these general principles, reinsurance coverage is further defined by specific contract wording and original policy coverage, of course.

The insurance/reinsurance marketplace at large has already taken steps to define "event" in the context of Y2K. The Reinsurance Research Council Bulletin # 10 reflects reinsurance opinion already expressed in the United States, U.K., Europe, and elsewhere, that January 1, 2000 and related Y2K or other date recognition problems do not constitute an event or an occurrence.

The following scenarios are hypothetical, and so, cannot speak to specific or complex events that may occur in the future. Rather, the examples are used here to present broad concepts only, and as such, they assume original policy coverage and the use of all possible recourse to settlement, including subrogation.

1a) An electric utility failure creates a power blackout in a portion of Ontario. Or, the Y2K failure at one power station causes an electric surge (a chain reaction) throughout a large portion of the power grid, resulting in loss to an even greater area.

The power outage is likely to be seen as one event. If so, catastrophe treaties will respond to the 168-hour "other" definition of event. Frozen pipes, water escape, food spoilage, and other similar insured perils will fall within the interpretation of insured (and reinsured) direct loss. Auto physical damage, criminal activity, fires, and any other insured loss not directly caused by the blackout would not be aggregated.

If temperatures are mild and only freezer contents are lost, the catastrophe treaty will still respond. It must be appreciated that it is the loss of power that invokes the treaty's hours clause, and not Canada's inherently cold January temperatures. Due to Canada's practical construction standards, temperatures must drop substantially before "freeze" becomes an "event" in its own right.

1b) If another power outage results from some sort of Y2K error at or about the same time as the first, then this second outage is a separate event. It too may invoke the catastrophe program, but only as a separate and distinct occurrence. Damage from this power outage cannot aggregate with the losses of the power failure in 1(a) above.

1c) Riot and civil commotion "associated with" the power blackout create extensive damage. Clearly, electrical failures do not cause riots ­ human reactions (panic) may. Although civil commotion may follow another event, the proximate cause is still the intervention of a human element.

2) A train derailment and the spilling of dangerous chemicals force a mass evacuation (as ordered by civil authority), leading to additional living expenses and business interruption. Because this is a single event, insured losses will likely be aggregated.

3) A single Y2K failure causes widespread loss of communication. Depending on circumstances and coverage issues, direct physical loss may be aggregated.

However, the loss of communication prevents police from receiving the alarm from a house being burglarized. The Y2K error did not cause the robbery. Even if the burglar chose January 1, 2000 as an opportune time to commit robberies, the communication failure is not the proximate cause of the break-in.

4) Several insured homes are heated by "a common type of furnace" or by furnaces with a common electrical component. On January 1, 2000, a number of these furnaces experience failures that result in loss (fire, or simply a shut-off that leads to frozen pipes). These losses are not aggregated, as they are separate events. Even if a manufacturer could be identified as having produced a single errant problem, the individual losses, despite an apparent commonality, remain separate failures, and as such, cannot be aggregated under an event catastrophe treaty.

5) A fire starts in a building and the fire suppression system in that and an adjacent building both fail to respond. Although loss is exacerbated by two Y2K errors, fire is a covered peril, and aggregation takes place for reasons other than Y2K.

6) A Canadian court deems a particular Y2K primary exclusion to be invalid. Under law, the remaining provisions govern. Absent a Y2K exclusion in the reinsurance agreement, coverage would follow the primary, to the extent otherwise intended.

7) An insurer inadvertently omits the Y2K exclusion in a primary policy. The parties will consider the treaty's Errors and Omissions Clause, but as a rule, exclusions are deemed by the treaty to be in place even if they are omitted in error.

8) Following January 1, 2000, questions are raised about claim expenses for losses that ultimately prove not to be covered.

The first question relates to a fraudulent claim for water damage and loss of freezer contents associated with the power blackout described earlier. These expenses will likely be aggregated with the blackout claims, because the defense of claims (claims that would be covered except for their fraudulent nature) is part and parcel of the reasonable handling of legitimate event related claims.

A second question involves hundreds of "broken VCR" claims submitted from across Canada. If there is no coverage and no loss under the primary policies, there can clearly be no coverage for the expenses under the catastrophe treaty. (Even if coverage could be found under primary policies, these are clearly separate events that cannot be aggregated.)

Clearly, the exposures faced by insurers and reinsurers are potentially severe. RRC and its members welcome further discussion on these and other Y2K questions. Continuing dialogue such as this is an important part of the planning and preparation that must be taken by our industry as we move into the year 2000. Reinsurers are prepared to adopt a partnership role in the face of Y2K, but insurers cannot interpret that role as assuming the full burden of anticipated losses.