The New Year 2000 Exclusions
Panacea or Placebo?
by Andrea E. Reisbord and James L. Haigh


Since the middle of this decade, we have been subject to increasing numbers of news articles regarding the impending Year 2000 computer problem. Depending on one''s point of view, this problem, also known as the Y2K problem or the millennium bug, has been either underestimated or overblown. Nevertheless, the issue is real, and it is coming up faster than any of us can imagine.
     The issue, simply put, relates to dates in computers. Back in the 1970s, when computer memory was incredibly expensive, programmers eliminated the "19" in dates to save precious memory. Today, 1 million characters of memory costs $3.00; in 1970 it cost closer to $3,000,000! Therefore, dates were programmed as 01/01/75, not 01/01/1975. Certain other dates were used for other purposes, too, such as 09/09/99 for eternity. This critical date has passed rather uneventfully. However, when the year 2000 comes around, as we know it must, some computers may read date sensitive software that is not year 2000 compliant as 01/01/00, and not interpret the date as the year 2000, but rather the year 1900!
     This seemingly simple problem has cost companies and individuals millions and millions of dollars to date to become "Y2K compliant" through hardware and software purchases, and consulting fees. Further, Y2K lawsuits already have been initiated, with mixed results. The United States Congress has weighed in with a new bill to curtail Y2K suits, and numerous state legislatures have attempted to legislate ways to control a feared flood of litigation.
     Areas of anticipated litigation include correction cost claims, business interruption claims, recall claims and external malfunction claims. Correction cost and business interruption claims implicate first party coverage; recall and external malfunction claims implicate third party liability coverage. The Y2K lawsuits already initiated include declaratory judgment actions to determine insurance coverage for Y2K damage claims (see, e.g., Cincinnati Ins. Co. v. Source Data Systems & Pineville Community Hospital, No. C-98-0144, (N.D. Iowa)).
     Many of our clients have sought to address potential Y2K litigation by introducing into their 1999 policies exclusions of year 2000 computer-related problems and losses. Typically in the form of an endorsement, most are either taken verbatim, or are modeled after, a Y2K exclusion drafted by the Insurance Services Office (ISO). For example, a typical Year 2000 exclusion in a CGL policy may resemble the following:

  1. This insurance does not apply to "bodily injury", "property damage", "personal injury" or "advertising injury" arising directly or indirectly out of:
    1. Any actual or alleged failure, malfunction or inadequacy of:
      1. Any of the following, whether belonging to any insured or to others:
        1. Computer hardware, including microprocessors or other Electronic Data Processing Equipment as may be described elsewhere in this policy;
        2. Computer application software or other Electronic Media and Records as may be described elsewhere in this policy;
        3. Computer operating systems and related software;
        4. Computer networks;
        5. Microprocessors (computer chips) not part of any computer system; or
        6. Any other computerized or electronic equipment or components; or
      2. Any other products and any services, data or functions that directly or indirectly use or rely upon, in any manner, any of the items listed in Paragraph 4.a.(1) of this endorsement;
      due to the inability to correctly recognize, process, distinguish, interpret or accept the year 2000 and beyond.
    2. Any advice, consultation, design, evaluation, inspection, installation, maintenance, repair, replacement or supervision provided or done by you or for you to determine, rectify or test for, any potential or actual problems described in Paragraph 4.a. of this endorsement.

   Such an exclusion in a first-party property coverage form may read as follows:
  1. We will not pay for loss or damage, caused by the following. Such loss or damage is excluded regardless of any other cause or event that contributes concurrently or in any sequence to the loss or damage.
    1. The failure, malfunction or inadequacy of:
      1. Any of the following, whether belonging to any insured or to others:
        1. Computer hardware, including microprocessors or other Electronic Data Processing Equipment as may be described elsewhere in this policy;
        2. Computer application software or other Electronic Media and Records as may be described elsewhere in this policy;
        3. Computer operating systems and related software;
        4. Computer networks;
        5. Microprocessors (computer chips) not part of any computer system; or
        6. Any other computerized or electronic equipment or components; or
      2. Any other products and any services, data or functions that directly or indirectly use or rely upon, in any manner, any of the items listed in Paragraph 6.a.(1) of this endorsement;

      due to the inability to correctly recognize, distinguish, interpret or accept one or more dates or times. An example is the inability of computer software to recognize the year 2000.
    2. Any advice, consultation, design, evaluation, inspection, installation, maintenance, repair, replacement or supervision provided or done by you or for you to determine, rectify or test for, any potential or actual problems described in Paragraph 6.a. of this endorsement.
  2. If excluded loss or damage, as described in Paragraph 6.a. of this endorsement results in a "Specified Cause of Loss" under the . . . Property Coverage Form, we will pay only for the loss or damage caused by such "Specified Cause of Loss".
  3. We will not pay for repair, replacement or modification of any items in Paragraph(s) 6.a.(1) or 6.a.(2) of this endorsement to correct any deficiencies or change any features.
     While insurers have sought through these exclusions to minimize their exposure for claims stemming from year 2000 problems, questions concerning the efficacy of these efforts necessarily will arise. This Forum Series addresses some of the roadblocks an insurer can expect to encounter when relying on the Year 2000 exclusion to preclude coverage in Minnesota.

Minnesota Requires Insurers to Give Insureds Written Notice When Substantially Reducing Coverage.
     Undoubtedly, many insureds will view the new Year 2000 exclusion as a reduction in coverage. In Canadian Universal Ins. Co., Ltd. v. Fire Watch, Inc., 258 N.W.2d 570 (Minn. 1977), the Minnesota Supreme Court adopted the rule, still relevant today, that when an insurer, by renewal of a policy or by an endorsement to an existing policy, substantially reduces the prior insurance coverage provided to the insured, the insurer has an affirmative duty to notify the insured in writing of the change in coverage. Id. at 575. Failure to give such notification will render the purported reduction in coverage void, and any question concerning an individual's insurance coverage shall then be determined in accordance with the terms of the original policy prior to the renewal or endorsement. Id. Relying on cases from other jurisdictions, the Minnesota Supreme Court reasoned that because insurance contracts are contracts of adhesion between parties not equally situated, the insurer, as the dominant and expert party in the field, must not only draft its policies in unambiguous terms, but must bring to the attention of the insured all provisions and conditions which create exceptions or limitations on the coverage. Id., quoting Allstate Ins. Co. v. Reeves, 66 Cal. App. 3d 464, 469, 136 Cal. Rptr. 159, 162 (1977). The notification rule is grounded upon notions of fairness and the generally established view that an insurer must convey to the insured an explanation of the provisions of its policy in terms the insured can comprehend. Id. at 574. Thus, assuming that the Year 2000 exclusions substantially reduce coverage, before any such exclusion will be deemed effective, the insured must comply with Canadian Universal's notice requirements.

Do the Year 2000 Exclusions Substantially Reduce Coverage?
     To state the obvious, a policy change substantially reduces coverage when it affects the basic insurance coverage available to the insured under its original policy. See, e.g., Samuelson v. Farm Bureau Mut. Ins. Co., 446 N.W.2d 428, 432 (Minn. App. 1989) (holding that mere change in claims procedure does not constitute a substantial reduction in coverage), pet. for rev. denied (Minn. Nov. 22, 1989). Far less obvious is whether the Year 2000 exclusions do in fact affect the basic insurance coverage available under the typical CGL and property coverage forms. The answer to this question likely will vary depending on the nature of the insured's business and the type of claim for which coverage is sought.
     Assume, for instance, that the insured is a private security firm that electronically monitors its clients'' homes and businesses. Due to a Y2K error, the insured's electronic monitoring equipment fails and, as a result, the insured fails to detect a fire that ultimately destroys a client's business. Certainly, the businessowner's claims against the insured will seek damages for "property damage." Was the "property damage," however, caused by an "occurrence"? While an argument could be made that an insured who fails to update its computer equipment in response to well known concerns over the millennium bug should foresee that its failure might result in loss, the insurer still may have a difficult time convincing a court that the property damage was not accidental. Similarly, an insurer likely would have an uphill battle were it to invoke the expected or intended injury exclusion. Other policy exclusions appear equally inapplicable. Thus, in this scenario a Year 2000 exclusion would appear to substantially reduce coverage.
     Let's assume, on the other hand, that your insured is a software manufacturer specializing in records keeping programs. The programs, however, are not Y2K compliant and several customers experience computer failure on January 1, 2000. All of the data in the computers becomes lost, including the customer's payroll and accounting, bookkeeping and billing entries, customer contacts and extensive data related to several projects for the customers'' clients. The typical CGL policy defines property damage as "physical injury to tangible property" or "loss of use of property that has not been physically injured." In Retail Systems, Inc. v. CNA Ins. Cos., 469 N.W.2d 735 (Minn. App. 1991), pet. for rev. denied (Minn. Aug. 2, 1991), the Minnesota Court of Appeals held that a computer tape containing data constituted tangible property under a general liability policy because the data on the tape was of a permanent value and was integrated completely with the physical property of the tape. Whether loss of data alone would constitute "property damage" as defined in a general liability policy is still subject to much debate.
      Generally, however, pure economic losses do not constitute property damage under a CGL policy. See, e.g., Tschimperle v. Aetna Casualty & Surety Co., 529 N.W.2d 421, 424 (Minn. App. 1995), pet. for rev. denied (Minn. May 31, 1995), and cases cited therein. An argument, however, could be made that the incorporation of the non-Y2K compliant software has caused the customer to lose the use of its computer system and, thus, has caused property damage. Even so, coverage may be excluded under the current CGL forms including the "impaired property," "sistership," "loss of use" and "completed operations" exclusions. In that case, the Year 2000 endorsement would not substantially reduce coverage.
      Finally, assume that the insured is the software company's client. Your insured makes a claim for first-party coverage under its property coverage form. Whether the Year 2000 exclusion substantially reduces the coverage afforded thereunder will depend on such questions as whether the insured is claiming direct physical loss to tangible property (and it appears that the insured is not), whether the loss is fortuitous, and whether potential exclusions, such as the latent defect and mechanical breakdown exclusions, are applicable. These are all unsettled questions, both in Minnesota and elsewhere.

Assuming the Year 2000 Exclusions Reduce Coverage, What Type of Notice Is Required?
      Fundamentally, the notice must be in writing. Canadian Universal, 258 N.W.2d at 575. Notice should be given to the insured by cover letter or a conspicuous heading to the amendatory endorsement, or some similar means, that the endorsement contains significant changes in coverage. Id.; Benton v. Mutual of Omaha Ins. Co., 500 N.W.2d 158, 160 (Minn. App. 1993), pet. for rev. denied (Minn. July 19, 1993). Further, the insurer should offer to explain and discuss the significance of the changes to the insured upon request. Canadian Universal, 258 N.W.2d at 575.
     In Campbell v. Insurance Service Agency, 424 N.W.2d 785 (Minn. App. 1988), for instance, the Campbells were insured beginning in 1978 under an all risk policy that included broad perils coverage. The Campbells'' 1984 renewal policy contained a "Special Notice to Policyholders" that identified a number of revisions, but apparently did not call attention to a "Special Provisions Amendment" that qualified the all-risk policy as inapplicable to "mixed perils," a substantial reduction in coverage. The Minnesota Court of Appeals rejected the insurer's argument that the Campbells'' receipt of the renewal policy was itself sufficient notice of the Special Provisions Amendment and invalidated the policy change. Not only did the insured receive no cover letter, but the policy was accompanied by a bold blue sheet stating that the renewal policy contained better protection than ever and making no mention of the Special Provisions Amendment that substantially reduced coverage. Id. at 790.
     The adequacy of notice was also an issue in Benton v. Mutual of Omaha Ins. Co., supra, a case involving an accident and disability insurance policy. Two years after Benton acquired the policy through his membership in the Minnesota State Bar Association, the policy was renegotiated and benefits were reduced from 520 weeks to 104 weeks. Notice was given to Benton in the form of a letter bearing the Minnesota State Bar Association letterhead and labeled "Minnesota State Bar Association Disability Insurance Program." Although this letter contained information about the decreased benefits, the Minnesota Court of Appeals found it to be inadequate. Benton, 500 N.W.2d at 160. First, it concluded that while the label may have informed the policyholder that the letter concerned his insurance, it did not indicate that significant changes were being made. Id. The court further noted that there was nothing conspicuous in the letter itself informing Benton that the letter was an important document that should be read with care. Third, the letter appeared to be promotional rather than informational. Finally, the court noted that it was not until the second page that the letter informed the insured of the reduction in disability benefits and that the one sentence notice was followed by a statement regarding attractive provisions that had been added. Id. The court concluded that the written notice employed a heading and content which did little to apprise a reasonable recipient that primary benefits had been decreased significantly, failed to put the limits prominently before the insured, and thus was inadequate. Id. at 161.
      In Horace Mann Ins. Co. v. Jackson, 1997 WL 537022 (Minn. App. 1997), pet. for rev. denied (Minn. Nov. 13, 1997), a case in which our firm was involved, the insured landowner carried a homeowner's policy that, for many years, contained a standard pollution exclusion with a sudden and accidental exception. In 1991, the policy was replaced with a new form containing an absolute pollution exclusion and a specific lead exclusion. Approximately 45 days prior to a renewal, the insurer sent to its insureds a mauve-colored 8" x 11" tri-folded brochure along with a copy of the new policy, a declaration sheet, the renewal notice and appropriate endorsements. The front of the brochure stated "Enclosed is your new homeowner policy." The first column on the inside advised the insured "to read about the improvements to your homeowner's coverage. You''ll see we''ve increased limits of coverage, expanded definitions, added some new coverages and improved service." The new lead paint exclusion was referenced on the back of the brochure where various "clarifications" were stated. The Minnesota Court of Appeals invalidated the policy change based on its belief that a substantial limitation on coverage sandwiched between various clarifications to a policy on the back page of a tri-fold stuffer under the heading "Major Clarifications" was not "prominently placed." The court concluded that the front and inside of the stuffer did not suggest, much less clearly state, that the policy in any way reduced coverage. In fact, the language appeared to suggest that coverage had been expanded.
     The lesson to be learned from the foregoing cases is that it is not sufficient to make passing reference to the Year 2000 exclusion in a cover letter accompanying or sent out in advance of the policy. The insured should be alerted to the exclusion either through a conspicuous heading on the amendatory endorsement or some other conspicuous means. Thus far, the exclusions we have reviewed do contain conspicuous headings. Nevertheless, the insured still should be provided with some explanation regarding the Year 2000 exclusion and its effects. Any reference to, or discussion of, the exclusion certainly should not be preceded or immediately followed by a statement to the effect that coverage is being expanded.
     

Who Is Entitled to Notice?
      In some cases, it will not be sufficient for the insurer to give notice solely to the named insured. In Bast v. Capitol Indem. Corp., 562 N.W.2d 24 (Minn. App. 1997), the Minnesota Court of Appeals held that when an insurance contract contains a standard form mortgage clause, two contracts are formed by the policy: a contract between the insurer and the insured and an independent contract between the insurer and the loss payee. When an insurance policy establishes an independent contract between the insurer and the loss payee through the use of a standard form mortgage clause, the loss payee is entitled to notice of any material change resulting in a substantial reduction in coverage, notwithstanding the acts of the insured. Id. at 28. In the absence of such notice, the independent contract between the insurer and the loss payee will remain unchanged.
     Based on the holding in Bast, insurers intending to introduce a Year 2000 endorsement should consider whether it might be necessary to also provide notice to any additional insureds listed by name on the policy.

When must the Requisite Notice Be Given?
     The notice required by Canadian Universal must be given before the effective date of the insured's renewal policy. Once the renewal policy goes into effect, it will not be sufficient to merely notify the insured that its policy contains Year 2000 exclusions. In such cases, the insurer will also need to obtain the insured's consent to the exclusions. Warrick v. Graffiti, Inc., 550 N.W.2d 303, 306 (Minn. App. 1996), pet. for rev. denied (Minn. Sept. 20, 1996). If the insurer does not notify the insured of substantial reductions in coverage contained in the renewal policy until after the policy has become effective, those changes can have no effect until the insured consents to them. Id. at 308-09. 1

Assuming the Insured Receives Adequate Notice of the Year 2000 Exclusions, Can the Exclusions Be Relied upon to Preclude Coverage for Year 2000 Losses and Claims?
     A final issue concerns whether the Year 2000 exclusion will even be applicable to a given claim for coverage. Although the Year 2000 exclusions became widely available sometime in 1998, most insurers first introduced them into 1999 renewal policies. Will the 1999, or 2000, renewal policy, however, be on the risk for a particular claim? The answer to this question, and hence the applicability of the Year 2000 exclusion, will depend on trigger theories adopted by the courts for year 2000 losses and claims. It appears, however, that the policies in effect in 1999 and 2000 will be deemed on the risk for year 2000 losses.
      With respect to third-party liability claims, most CGL policies provide that the insurer will cover property damage that either takes place during the policy period or is caused by an occurrence during the policy period. The generally accepted rule in Minnesota is that the time of the occurrence is not the time the wrongful act was committed, i.e. when the non-Y2K compliant software was installed, but the time the complaining party was actually damaged. Jenoff , Inc. v. New Hampshire Ins. Co., 558 N.W.2d 260, 262 (Minn. 1997). This is consistent with the "actual injury" or "injury-in fact" trigger adopted in environmental cases, the essence of which is that each insurer is held liable only for those damages which occur during its policy period. Northern States Power Co. v. Fidelity & Cas. Co. of New York, 523 N.W.2d 657, 662 (Minn. 1994). In order to trigger a policy under the "injury-in fact" rule, the insured must show that some damage occurred during the policy period. Id. Thus, it would appear that, under the actual injury or injury-in fact rule, those policies in effect at the time of an actual computer failure, presumably the 1999 and 2000 policies, will be on the risk and the exclusion will be applicable. 2
     Minnesota law provides less guidance with respect to first-party insurance claims. In Sentinel Management v. Aetna Cas. & Surety Co., Hennepin County District Court File No. CT 94-1429, however, a case in which our firm was involved, the trial court adopted a manifestation trigger as the appropriate trigger in a first-party coverage case. The insured in Sentinel was seeking first-party coverage for asbestos abatement. Under the manifestation theory, coverage is triggered when appreciable damage occurs and is or should be known to the insured. Prudential-LMI Commerical Ins. v. Superior Court, 798 P.2d 1230, 1247 (Cal. 1990). The trial court concluded that the manifestation trigger best served the purpose of first-party insurance and best met the reasonable expectations of the parties to a first-party insurance policy since, prior to the manifestation of damage, the loss is still a contingency under the policy and the insured has not suffered a compensable loss. Once the loss is manifested, however, the risk is no longer contingent; rather an event has occurred that triggers indemnity unless the event is specifically excluded under the policy terms. Prudential-LMI, 798 P.2d at 1246-47. The Sentinel case twice went up to the Minnesota Court of Appeals, but in neither appeal was the court's adoption of the manifestation trigger challenged. Rather, the court of appeals proceeded on the assumption that that was the appropriate trigger. Assuming that to be true, coverage for year 2000 losses in Minnesota should rest with those policies that were in effect when actual loss is sustained by the insured or it becomes apparent to the insured that remediation efforts are necessary.

Conclusion
      While the year 2000 is fast approaching, those insurers that have not already done so can still protect themselves against year 2000 computer-related claims by Minnesota insureds whose policies will come up for renewal between now and the end of the year.3
     Insurers who wish to rely upon Year 2000 exclusions must be sure that the insured is adequately notified of the exclusion and its terms. Additionally, any mid-term changes would require the insured's consent. The Year 2000 exclusions, however, will only be of use if the policies to which they are endorsed are triggered. While it appears that, under the various triggers considered by the Minnesota courts, policies in effect in 1999 and 2000 will be deemed on the risk for any year 2000 losses, the issue remains unsettled.

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Footnotes:
1 When adequate notice of policy changes is given prior to, or at the time of, renewal, consent will ordinarily be implied by the insured's act of renewing the policy. Warrick, 550 N.W.2d at 306 BACK

2 It should be noted, however, that, applying an "injury-in fact" analysis in a third-party property damage context, the Second Circuit Court of Appeals determined that in the case of asbestos contamination, the injury occurs when the asbestos is installed in the building because the need to remediate the asbestos, which occurs upon the product's installation, remains unchanged. See, e.g., Maryland Cas. Co. v. W.R. Grace & Co., 23 F.3d 617, 628 (2nd Cir. 1993). A similar argument could be made with respect to the installation of a defective software program. BACK

3 This is not to say, however, that the year 2000 exclusion itself will not be subject to some litigation. BACK
Andrea E. Reisbord

      Born Los Angeles, California, June 24, 1965; admitted to bar, 1990, California, U. S. District Court, Central District of California; 1992, Minnesota; 1994, U.S. District Court, District of Minnesota. Education: B.A., Occidental College, magna cum laude, Phi Beta Kappa, 1987; J.D., University of California, Los Angeles, 1990. Member: Hennepin County Bar Association; Minnesota State Bar Association; California Bar Association (inactive); American Bar Association; Minnesota Defense Lawyers Association, Minnesota Women Lawyers.
Reisbord

direct dial number: (612)525-6925
e-mail: aer@cousineaulaw.com

     
James L. Haigh

      Born Kankakee, Illinois, June 19, 1948; admitted to bar, 1978, Minnesota, U.S. District Court, District of Minnesota and the Eighth Circuit. Education: B.A., University of Illinois, 1970; M.A., University of Southern California, 1973; J.D., William Mitchell College of Law, 1978; Lecturer, Minnesota Institute of Legal Education: "Coverage B in CGL Policies," 1987 and 1992; "Primary, Excess and Other Insurance," 1991 and 1993; "Legal Ethics for the Insurance Defense Attorney," 1994; "Introducing the 1996 ISO CGL Policy," 1996; "Insurance Coverage Institute," 1997. Qualified Neutral Mediator and Arbitrator under Rule 114 of the Minnesota General Rules of Practice. Member: Ramsey County Bar Association; Minnesota State Bar Association; American Bar Association; Defense Research Institute; Minnesota Defense Lawyers Association.
Haigh

direct dial number: (612)525-6943
e-mail: jlh@cousineaulaw.com

  
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