Specialty Recall Insurance Coverage

Which Events Trigger a Specialty Policy?

There is considerable confusion among policyholders about the insured events that trigger a specialty policy. In general, a specialty policy may be triggered by one or more of the following insured events:

• Accidental contamination;
• Malicious product tampering;
• Adverse publicity concerning contamination or tampering; or
• Government recall.

Accidental Contamination

To date, most of the litigation under specialty policies has focused on the “accidental contamination” trigger. Depending on the wording, the “accidental contamination” might require the policyholder to show that there has been actual contamination of its product, or it might require only suspected contamination. If the insurer requires the policyholder to show actual contamination, the requirement may present two challenges. First, because a policyholder must act quickly to protect public health, it might not have the opportunity to confirm that contamination has actually occurred before making the decision to recall the product.

Second, the actual contamination requirement does not track the recall classifications of the Food and Drug Administration (“FDA”). The FDA's definition of a Class I recall ' available on its website ' which is its most serious recall category, is a situation in which there is “a reasonable probability that the use of or exposure to a violative product will cause serious adverse health consequences or death.”

A policyholder could find itself in the position of recalling on its own initiative or being asked by the FDA to recall based on this “reasonable probability” standard, but not being able to satisfy the definition of “accidental contamination” under its specialty policy because it cannot prove its product was actually contaminated. This is a challenge that Wornick Co., a company that provides meals-ready-to-eat (“MREs”) for the military, is currently facing as it seeks coverage for recall-related expenses under its specialty policy with Houston Casualty Company. In 2009, Wornick recalled its MREs after government inspectors discovered salmonella in dairy shake blends provided by another vendor for use in the MREs. Complaint at ” 4-6, Wornick Co. v. Houston Cas. Co., No. 1:11-cv-00391 (S.D. Ohio June 15, 2011).

The policy defines “accidental product contamination” as “any accidental or unintentional contamination, impairment or mislabeling ' during the manufacture, blending, mixing ' or processing” of the insured's product. Houston Casualty has denied coverage on the basis of the accidental contamination requirement because none of the dairy blends in Wornick's MREs were found to be actually contaminated and there is no evidence to indicate that the contaminated blends were sold to Wornick. Id. Ex. I. Wornick filed suit in the summer of 2011 and the case is pending in the U.S. District Court for the Southern District of Ohio.

Some policies, by contrast, require only that the policyholder have “reasonable cause to believe” contamination has occurred. From a policyholder's perspective, this definition of accidental contamination is preferable to the “actual contamination” requirement. Not only does it afford broader coverage for product recalls, but it also is more consistent with both FDA regulations and the realities of administering a recall.

Insurers may also rely on other language in the definition of “accidental product contamination” as a basis for denying coverage. In a recently decided case interpreting a definition of “accidental product contamination” almost identical to the definition in Wornick, the outcome turned on the source of the contamination. The policyholder, Caudill Seed, recalled its peanut products and alfalfa seed products due to contamination incidents. Caudill purchased the peanut products from Peanut Corporation of America (“PCA”), a supplier whose facilities were the source of the contamination and whose products were the subjects of a highly publicized recall in early 2009. However, the FDA determined that the source of the alfalfa seed contamination was Caudill's facilities.

Caudill sought coverage under its specialty policy with Houston Casualty Co. for both incidents, but Houston refused to provide coverage for the peanut contamination. Houston argued that the contamination of Caudill's peanut products did not occur “during the manufacture ' preparation, production or processing” of the insured's products, as required by the policy language, because it originated at PCA's facilities in Georgia. The court, ruling on the parties' cross motions for summary judgment, agreed. Caudill Seed & Warehouse Co., Inc. v. Houston Cas. Co., No. 3:10-cv-299-JHM, 2011 U.S. Dist. LEXIS 146418, at *8-9 (W.D. Ky. Dec. 20, 2011). It remains to be seen whether other courts will interpret similar language to mean that the original source of contamination must be the policyholder's facilities, and that the policyholder's incorporation of a supplier's contaminated ingredients into its products does not constitute contamination “during the manufacture ' preparation, production or processing.”

Product Tampering

The second type of insured event is malicious tampering, which is defined by Chartis' sample product recall insurance form as any actual or threatened, “intentional, malicious and wrongful alteration or contamination of the insured product(s), by any person (including an employee of the insured), so as to render the insured product(s) unfit or dangerous for its intended use or to create such impression to the public.” Such coverage usually includes product extortion, which is defined as a demand for money made in conjunction with a threat to tamper with the policyholder's product.

Adverse Publicity

Some policies provide coverage for adverse publicity in connection with a contamination or tampering incident, provided that the insured product or the policyholder's brand name has been specifically identified.

Covered adverse publicity could include the listing of the policyholder or its product in an FDA enforcement report or an FDA 483 (inspection) report posted on the FDA website. However, adverse publicity coverage might not be triggered by an FDA advisory that warns consumers not to consume a specific category of food, such as lettuce or ground beef, regardless of the brand or producer. Similarly, coverage might not be triggered by adverse publicity about a competitor's product, even though that publicity might adversely affect the policyholder's sales of the same type of product.

In Caudill, the court found no “adverse publicity” as defined under the policy with respect to the peanut product contamination claim. Even though the Department of Health and Human Services had sent Caudill a letter agreeing with the recall and indicating that the recall would be reported in an upcoming issue of the FDA Weekly Enforcement Report, no such publication occurred. Caudill, 2011 U.S. Dist. LEXIS 146418, at *9. In contrast, the court did find that “[t]here was publicity that cited [Caudill] as the source of the Salmonella outbreak” traced to alfalfa seeds. The insurer, Houston, agreed that the alfalfa claim was covered under the adverse publicity provision of the policy, but it contested the amount. Id. at *9-10. The court ultimately ruled that the insurer had to cover the value of recalled or destroyed contaminated products, as well as labor costs and legal fees incurred to conduct the recall, and remanded the case for further proceedings about the reasonableness of Caudill's expenses for each covered item. Id. at *12, 15-17.

For a different reason, even with respect to the alfalfa claim, the Caudill court denied coverage for Caudill's public relations consultants' fees. Id. at *14. Many specialty policies, including Caudill's, contain provisions covering reasonable expenses in connection with a company's public relations response to the adverse publicity. However, some policies, again including Caudill's, provide that they will indemnify the policyholder only for reasonable expenses that are approved in advance by the insurer. Because Caudill had not sought and obtained Houston's prior written approval for the PR consultants' fees, the court denied coverage. Id. at *13. To ensure full coverage, a policyholder must be careful to comply with the policy's terms and obligations.

Government Recalls

Some insurers also include government recalls as insured events under their specialty coverage. In the past, such provisions have had limited utility in the United States because the FDA did not have mandatory recall authority over food items other than infant formula. However, on Jan. 4, 2011, President Obama signed the Food Safety Modernization Act, granting FDA mandatory recall authority. Future mandatory FDA recalls might trigger coverage under policies that list government recalls as insured events.

Key Exclusions

Specialty policies contain several key exclusions. Typically, there is an exclusion for regulatory violations, which can be problematic for policyholders, like food and beverage companies, in highly regulated industries.

Other important exclusions exclude:

• The policyholder's liabilities to third parties for bodily injury or property damage, which typically is covered by third-party liability insurance policies;
• Fraudulent, illegal or criminal acts by a director or officer of the policyholder; and
• Circumstances that were known to the policyholder before the inception of the policy.

Insurers might also attempt to limit coverage by imposing low sub-limits on certain events or losses.

Which Recall-Related Losses Are Covered?

Once the specialty policy has been triggered, the policyholder must determine which recall-related expenses the policy will pay. Those expenses are listed in the definition of loss, which may include some or all of the following:

• Transporting, storing and disposing of the recalled product;
• Hiring and paying temporary staff to manage the recall;
• Paying overtime to regular employees;
• Pre-recall testing;
• Customer recall expenses;
• Product rehabilitation costs;
• Loss of gross profits; and
• Crisis management expenses.

Some specialty policies provide coverage for third-party recall expenses or the recall-related costs for which the policyholder is legally obligated to reimburse its customers. This coverage differs from the policyholder's liability to its customer for damage to the customer's product, which is typically covered by a third-party general liability policy. Instead, this coverage captures the customer's costs of recalling the customer's product and may also include customer loss of profits and customer rehabilitation expenses.

Covered recall-related losses might also include the policyholder's loss of profits, or costs incurred to re-establish pre-recall sales level of the recalled product, including expenditures for sales, marketing, shelf space and slotting.

Endorsements that purport to pick and choose particular covered costs from a generic list in the policy's base form should be scrutinized. In Caudill, for example, the portion of the policy defining the covered losses was deleted and replaced by an endorsement that omitted several categories of costs, but otherwise made no change to the policy language. The introductory language stated that the policy provided coverage for “'any reasonable expenses necessarily incurred' and then include[d] a non-exhaustive list of twelve items.” Caudill, 2011 U.S. Dist. LEXIS 146418, at *12. With respect to cost categories simply omitted from the amending endorsement, such as the value of recalled or destroyed products, the court found that the policy did not expressly provide coverage for those categories (as the original policy had). However, because the policy also did not expressly exclude those items, the court held that the effect of removing the original provisions did not result in the exclusion of coverage. Id. Consequently, the only remaining question was “whether the value of the destroyed in-house inventory and returned material from customers were reasonable recall expenses that were necessarily incurred in the procedure of recall, inspection, examination, destruction or disposal.” Id. at *13. Since this question raised issues of fact, the court found that summary judgment was inappropriate. Id.

Important Terms

An application for specialty recall coverage typically asks the prospective policyholder to provide detailed information about its operations, locations, products, suppliers, contracts, quality control practices and recall history. A company can make itself a more attractive risk to an insurer if it has stringent quality control practices, such as crisis management preparation, product traceability, batch coding, and hazard analysis and critical control point (“HAACP”) plans.

Specialty policies sometimes contain confidentiality provisions that require the policyholder to refrain from disclosing the existence of the policy to any person, including others within the policyholder's organization, unless required to do so by law or other terms of the policy. Specialty policies also might contain stringent notice provisions that require the policyholder to give notice of a potentially covered event in a very compressed time frame.

Finally, specialty policies frequently contain dispute resolution and choice-of-law clauses that require the policyholder to litigate or arbitrate in an offshore forum and/or under foreign law, for example, arbitration in London under UK law. Such requirements can make it impractical or cost prohibitive for the policyholder to enforce its insurance contract, so alternative formulations should be discussed with the insurer when the policy is purchased.

Conclusion

Specialty insurance policies are becoming an increasingly common way for companies to manage the financial risks of recall-related losses. However, because specialty policies vary considerably, it is critical for a policyholder to be familiar with its policy's specific terms in order to understand the scope of the coverage provided and the requirements for pursuing a claim. Although there is now little case law to guide these determinations, recent cases have highlighted certain limitations on such coverage, and major developments are likely to occur over the next few years.

Marialuisa S. Gallozzi and Suzan F. Charlton are attorneys with Covington & Burling LLP. Gallozzi is a member of this newsletter's Board of Editors. The opinions expressed herein are those of the authors alone, not of Covington & Burling or the firm's clients. Further, the information herein is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the subjects mentioned herein.

With the cost and frequency of product recalls on the rise, many companies are considering purchasing specialty policies to cover certain recall-related losses that are often excluded from general liability and property policies. Specialty coverage first appeared in the late 1980s to fill this niche. Although these policies are also frequently referred to as “product recall” insurance, they provide coverage for recall-related losses only when those losses are caused by specific triggering events, typically accidental contamination and malicious product tampering.

When Lloyd's of London and Chartis (formerly known as AIG) began offering specialty coverage in the late 1980s, as a result of the much-publicized Tylenol' tampering incident, they had little competition or loss experience. Since that time, the market for specialty coverage has grown to $350 million to $550 million in premiums annually.

The language of specialty policies varies considerably. As explained below, few cases provide guidance about how such policies will be interpreted and applied by the courts, but some recent decisions highlight limitations on their scope of coverage.

Which Events Trigger a Specialty Policy?

There is considerable confusion among policyholders about the insured events that trigger a specialty policy. In general, a specialty policy may be triggered by one or more of the following insured events:

• Accidental contamination;
• Malicious product tampering;
• Adverse publicity concerning contamination or tampering; or
• Government recall.

Accidental Contamination

To date, most of the litigation under specialty policies has focused on the “accidental contamination” trigger. Depending on the wording, the “accidental contamination” might require the policyholder to show that there has been actual contamination of its product, or it might require only suspected contamination. If the insurer requires the policyholder to show actual contamination, the requirement may present two challenges. First, because a policyholder must act quickly to protect public health, it might not have the opportunity to confirm that contamination has actually occurred before making the decision to recall the product.

Second, the actual contamination requirement does not track the recall classifications of the Food and Drug Administration (“FDA”). The FDA's definition of a Class I recall ' available on its website ' which is its most serious recall category, is a situation in which there is “a reasonable probability that the use of or exposure to a violative product will cause serious adverse health consequences or death.”

A policyholder could find itself in the position of recalling on its own initiative or being asked by the FDA to recall based on this “reasonable probability” standard, but not being able to satisfy the definition of “accidental contamination” under its specialty policy because it cannot prove its product was actually contaminated. This is a challenge that Wornick Co., a company that provides meals-ready-to-eat (“MREs”) for the military, is currently facing as it seeks coverage for recall-related expenses under its specialty policy with Houston Casualty Company. In 2009, Wornick recalled its MREs after government inspectors discovered salmonella in dairy shake blends provided by another vendor for use in the MREs. Complaint at ” 4-6, Wornick Co. v. Houston Cas. Co., No. 1:11-cv-00391 (S.D. Ohio June 15, 2011).

The policy defines “accidental product contamination” as “any accidental or unintentional contamination, impairment or mislabeling ' during the manufacture, blending, mixing ' or processing” of the insured's product. Houston Casualty has denied coverage on the basis of the accidental contamination requirement because none of the dairy blends in Wornick's MREs were found to be actually contaminated and there is no evidence to indicate that the contaminated blends were sold to Wornick. Id. Ex. I. Wornick filed suit in the summer of 2011 and the case is pending in the U.S. District Court for the Southern District of Ohio.

Some policies, by contrast, require only that the policyholder have “reasonable cause to believe” contamination has occurred. From a policyholder's perspective, this definition of accidental contamination is preferable to the “actual contamination” requirement. Not only does it afford broader coverage for product recalls, but it also is more consistent with both FDA regulations and the realities of administering a recall.

Insurers may also rely on other language in the definition of “accidental product contamination” as a basis for denying coverage. In a recently decided case interpreting a definition of “accidental product contamination” almost identical to the definition in Wornick, the outcome turned on the source of the contamination. The policyholder, Caudill Seed, recalled its peanut products and alfalfa seed products due to contamination incidents. Caudill purchased the peanut products from Peanut Corporation of America (“PCA”), a supplier whose facilities were the source of the contamination and whose products were the subjects of a highly publicized recall in early 2009. However, the FDA determined that the source of the alfalfa seed contamination was Caudill's facilities.

Caudill sought coverage under its specialty policy with Houston Casualty Co. for both incidents, but Houston refused to provide coverage for the peanut contamination. Houston argued that the contamination of Caudill's peanut products did not occur “during the manufacture ' preparation, production or processing” of the insured's products, as required by the policy language, because it originated at PCA's facilities in Georgia. The court, ruling on the parties' cross motions for summary judgment, agreed. Caudill Seed & Warehouse Co., Inc. v. Houston Cas. Co., No. 3:10-cv-299-JHM, 2011 U.S. Dist. LEXIS 146418, at *8-9 (W.D. Ky. Dec. 20, 2011). It remains to be seen whether other courts will interpret similar language to mean that the original source of contamination must be the policyholder's facilities, and that the policyholder's incorporation of a supplier's contaminated ingredients into its products does not constitute contamination “during the manufacture ' preparation, production or processing.”

Product Tampering

The second type of insured event is malicious tampering, which is defined by Chartis' sample product recall insurance form as any actual or threatened, “intentional, malicious and wrongful alteration or contamination of the insured product(s), by any person (including an employee of the insured), so as to render the insured product(s) unfit or dangerous for its intended use or to create such impression to the public.” Such coverage usually includes product extortion, which is defined as a demand for money made in conjunction with a threat to tamper with the policyholder's product.

Adverse Publicity

Some policies provide coverage for adverse publicity in connection with a contamination or tampering incident, provided that the insured product or the policyholder's brand name has been specifically identified.

Covered adverse publicity could include the listing of the policyholder or its product in an FDA enforcement report or an FDA 483 (inspection) report posted on the FDA website. However, adverse publicity coverage might not be triggered by an FDA advisory that warns consumers not to consume a specific category of food, such as lettuce or ground beef, regardless of the brand or producer. Similarly, coverage might not be triggered by adverse publicity about a competitor's product, even though that publicity might adversely affect the policyholder's sales of the same type of product.

In Caudill, the court found no “adverse publicity” as defined under the policy with respect to the peanut product contamination claim. Even though the Department of Health and Human Services had sent Caudill a letter agreeing with the recall and indicating that the recall would be reported in an upcoming issue of the FDA Weekly Enforcement Report, no such publication occurred. Caudill, 2011 U.S. Dist. LEXIS 146418, at *9. In contrast, the court did find that “[t]here was publicity that cited [Caudill] as the source of the Salmonella outbreak” traced to alfalfa seeds. The insurer, Houston, agreed that the alfalfa claim was covered under the adverse publicity provision of the policy, but it contested the amount. Id. at *9-10. The court ultimately ruled that the insurer had to cover the value of recalled or destroyed contaminated products, as well as labor costs and legal fees incurred to conduct the recall, and remanded the case for further proceedings about the reasonableness of Caudill's expenses for each covered item. Id. at *12, 15-17.

For a different reason, even with respect to the alfalfa claim, the Caudill court denied coverage for Caudill's public relations consultants' fees. Id. at *14. Many specialty policies, including Caudill's, contain provisions covering reasonable expenses in connection with a company's public relations response to the adverse publicity. However, some policies, again including Caudill's, provide that they will indemnify the policyholder only for reasonable expenses that are approved in advance by the insurer. Because Caudill had not sought and obtained Houston's prior written approval for the PR consultants' fees, the court denied coverage. Id. at *13. To ensure full coverage, a policyholder must be careful to comply with the policy's terms and obligations.

Government Recalls

Some insurers also include government recalls as insured events under their specialty coverage. In the past, such provisions have had limited utility in the United States because the FDA did not have mandatory recall authority over food items other than infant formula. However, on Jan. 4, 2011, President Obama signed the Food Safety Modernization Act, granting FDA mandatory recall authority. Future mandatory FDA recalls might trigger coverage under policies that list government recalls as insured events.

Key Exclusions

Specialty policies contain several key exclusions. Typically, there is an exclusion for regulatory violations, which can be problematic for policyholders, like food and beverage companies, in highly regulated industries.

Other important exclusions exclude:

• The policyholder's liabilities to third parties for bodily injury or property damage, which typically is covered by third-party liability insurance policies;
• Fraudulent, illegal or criminal acts by a director or officer of the policyholder; and
• Circumstances that were known to the policyholder before the inception of the policy.

Insurers might also attempt to limit coverage by imposing low sub-limits on certain events or losses.

Which Recall-Related Losses Are Covered?

Once the specialty policy has been triggered, the policyholder must determine which recall-related expenses the policy will pay. Those expenses are listed in the definition of loss, which may include some or all of the following:

• Transporting, storing and disposing of the recalled product;
• Hiring and paying temporary staff to manage the recall;
• Paying overtime to regular employees;
• Pre-recall testing;
• Customer recall expenses;
• Product rehabilitation costs;
• Loss of gross profits; and
• Crisis management expenses.

Some specialty policies provide coverage for third-party recall expenses or the recall-related costs for which the policyholder is legally obligated to reimburse its customers. This coverage differs from the policyholder's liability to its customer for damage to the customer's product, which is typically covered by a third-party general liability policy. Instead, this coverage captures the customer's costs of recalling the customer's product and may also include customer loss of profits and customer rehabilitation expenses.

Covered recall-related losses might also include the policyholder's loss of profits, or costs incurred to re-establish pre-recall sales level of the recalled product, including expenditures for sales, marketing, shelf space and slotting.

Endorsements that purport to pick and choose particular covered costs from a generic list in the policy's base form should be scrutinized. In Caudill, for example, the portion of the policy defining the covered losses was deleted and replaced by an endorsement that omitted several categories of costs, but otherwise made no change to the policy language. The introductory language stated that the policy provided coverage for “'any reasonable expenses necessarily incurred' and then include[d] a non-exhaustive list of twelve items.” Caudill, 2011 U.S. Dist. LEXIS 146418, at *12. With respect to cost categories simply omitted from the amending endorsement, such as the value of recalled or destroyed products, the court found that the policy did not expressly provide coverage for those categories (as the original policy had). However, because the policy also did not expressly exclude those items, the court held that the effect of removing the original provisions did not result in the exclusion of coverage. Id. Consequently, the only remaining question was “whether the value of the destroyed in-house inventory and returned material from customers were reasonable recall expenses that were necessarily incurred in the procedure of recall, inspection, examination, destruction or disposal.” Id. at *13. Since this question raised issues of fact, the court found that summary judgment was inappropriate. Id.

Important Terms

An application for specialty recall coverage typically asks the prospective policyholder to provide detailed information about its operations, locations, products, suppliers, contracts, quality control practices and recall history. A company can make itself a more attractive risk to an insurer if it has stringent quality control practices, such as crisis management preparation, product traceability, batch coding, and hazard analysis and critical control point (“HAACP”) plans.

Specialty policies sometimes contain confidentiality provisions that require the policyholder to refrain from disclosing the existence of the policy to any person, including others within the policyholder's organization, unless required to do so by law or other terms of the policy. Specialty policies also might contain stringent notice provisions that require the policyholder to give notice of a potentially covered event in a very compressed time frame.

Finally, specialty policies frequently contain dispute resolution and choice-of-law clauses that require the policyholder to litigate or arbitrate in an offshore forum and/or under foreign law, for example, arbitration in London under UK law. Such requirements can make it impractical or cost prohibitive for the policyholder to enforce its insurance contract, so alternative formulations should be discussed with the insurer when the policy is purchased.

Conclusion

Specialty insurance policies are becoming an increasingly common way for companies to manage the financial risks of recall-related losses. However, because specialty policies vary considerably, it is critical for a policyholder to be familiar with its policy's specific terms in order to understand the scope of the coverage provided and the requirements for pursuing a claim. Although there is now little case law to guide these determinations, recent cases have highlighted certain limitations on such coverage, and major developments are likely to occur over the next few years.

Marialuisa S. Gallozzi and Suzan F. Charlton are attorneys with Covington & Burling LLP. Gallozzi is a member of this newsletter's Board of Editors. The opinions expressed herein are those of the authors alone, not of Covington & Burling or the firm's clients. Further, the information herein is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the subjects mentioned herein.