Insurance Coverage and Bad Faith

On December 13, 2024, the Supreme Court of North Carolina broke with the nationwide trend, holding that, absent a virus exclusion, commercial property insurance policies cover losses covered by the shutdown orders issued in respond to the COVID‑19 pandemic. In North State Deli, LLC v. The Cincinnati Ins. Co., Case No. 225PA21‑2, the Supreme Court of North Carolina held that businesses were entitled to coverage under their respective policies’ Business Income coverages, as a reasonable insured would understand losses caused by the shutdown orders as qualifying as the “direct physical loss” to property required for coverage. Cato Corp. v. Zurich Am. Ins. Co., Case No. 353PA23 confirmed this, but nonetheless concluded that an exclusion of losses caused by contamination, which was defined to include the actual presence of any virus, barred coverage for losses caused by the shutdown orders.

North State Deli arose from various shutdown orders that, among other things, limited the business activities of restaurants and limited access to their premises. It addressed the claims of multiple restaurants under multiple commercial property insurance policies, each of which provided Business Income coverage on the following basis:

We will pay for the actual loss of “Business Income” you sustain during the necessary “suspension” of your “operations” during the “period of restoration”. The “suspension” must be caused by direct “loss” to property at “premises”. …. The “loss” must be caused by or result from a Covered Cause of Loss.

The policies defined “Covered Cause of Loss” as “direct ‘loss’ unless the ‘loss’ is excluded or limited in this Coverage Part,” and defined “loss” as “accidental physical loss or accidental physical damage.” The policies did not exclude losses caused by viruses.

The parties in North State Deli differed on whether the restaurants’ loss of full use of their business premises, and limitations on their business activities, as the result of the shutdown orders was “direct accidental physical loss or accidental physical damage” necessary to qualify as a “Covered Cause of Loss.” In interpreting the policies, the Supreme Court of North Carolina relied upon the principle of North Carolina law that insurance policies “should be given that construction which a reasonable person in the position of the insured would have understood it to mean.” Applying this principle, and referring to the dictionary definitions of “direct,” “physical,” and “loss,” the Supreme Court of North Carolina held that “a covered cause of loss must, absent an intervening factor, result in the material deprivation, dispossession, or destruction of property.”

This definition is sensitive to the “use” for which the property is insured, as an insured would reasonably expect that its insurance policy would protect against threats that make the property unusable for the purpose for which it is insured. Thus, an insured’s loss of use of its property through, for example, enforcement of the shutdown orders, qualifies as a “direct physical loss.” The Supreme Court of North Carolina found this conclusion supported by the fact the policies’ references to “direct physical loss” and “direct physical damage” were written in the disjunctive, indicating that “loss” and “damage” had to have distinct meanings. The Supreme Court of North Carolina recognized that the distinct meaning of “loss” could be one of degree, where “loss” is the complete destruction or total deprivation of property and “damage” is a less‑than‑complete impairment or alteration. But, a reasonable insured could also read “loss” in this context as purposefully broader than “damage” that could encompass dispossession, deprivation, or impairment of use or function. The policies did not clearly delineate which interpretation should apply, and the ambiguity mandated a construction in favor of coverage.

The policies’ definition of “period of restoration” offered further support for a finding of coverage, according to the Supreme Court of North Carolina. The definition provided that the “period of restoration” terminated on the earlier of the date by which property should be repaired, rebuilt or replaced, the date when the business resumed at a new permanent location, or twelve consecutive months after the direct physical loss or damage. This definition could be construed as requiring that all three alternative dates be capable of identification, as, otherwise, it would be impossible to calculate the “period of restoration.” This would suggest that “direct physical losses” are only those capable of being repaired, rebuilt, or replaced. At the same time, however, a reasonable insured could conclude that if two of the three alternatives are inapplicable – here, repairing, rebuilding, or replacing lost property and resuming business at a new location – then the third alternative must apply. And, here, the temporal limit on the “period of restoration” offered no insight into the definition of “direct physical loss.”

Next, the Supreme Court of North Carolina noted that, while the policies excluded losses caused by certain governmental actions, it did not exclude losses caused by virus‑related governmental orders. This, combined with the fact that the policies did not include a virus exclusion, would cause a reasonable insured to expect that the policies covered losses caused by the shutdown orders. Indeed, concerns about viruses and their consequences for business operations were common enough in the restaurant industry that knowledge that other policies excluded virus risks, while these policies did not, would cause the reasonable insured to expect coverage.

In the end, North State Deli held that “[a]t bottom, a reasonable person in the position of the insured would understand the restaurants’ policies to include coverage for business income lost when virus‑related government orders deprive the policyholder restaurants of their ability to physically use and physically operate property at their insured business premises.” Thus, based upon the mandate that insurance policies be interpreted in accordance with the reasonable insured’s understanding thereof, the Supreme Court of North Carolina held that the policies obligated Cincinnati to cover the insureds’ Business Income losses.

North State Deli’s companion case, Cato Corp., confirmed the holding that losses caused by the shutdown orders qualified as “direct physical loss.” But, unlike North State Deli, the commercial property insurance policy held by the insured clothing store retailer excluded losses caused by viruses. This exclusion proved determinative, as the Supreme Court of North Carolina held that the policy at issue excluded coverage for the insured’s losses from the government shutdown orders.

The policy in Cato Corp. provided that Zurich must pay for:

the actual Time Element loss the Insured sustains, as provided in the Time Element Coverages, during the Period of Liability. The Time Element loss must result from the necessary Suspension of the insured’s business activities at an Insured Location. The Suspension must be due to direct physical loss of or damage to Property (of the type insurable under this Policy other than Finished Stock) caused by a Covered Cause of Loss at the Location ….

The policy, however, excluded Contamination, which was defined to include “any condition of the property due to the actual presence of any … virus.”

Relying upon North State Deli, the Supreme Court of North Carolina held that the insured proved the “direct physical loss” required for coverage. But, unlike the policy in North State Deli, the policy at issue specifically excluded losses caused by conditions of the property due to the actual presence of viruses, and this, according to the policy, “include[ed] the inability to use or occupy property or any cost of making property safe or suitable for use or occupancy.” Cato’s allegations that the COVID‑19 virus made its premises unsafe and non‑functional for their intended uses and that the shutdown orders forced its businesses to close, curtail operations, and remediate their spaces met this definition – a reasonable insured would understand these allegations to qualify as “condition[s] of property due to the actual presence of any … virus.” Accordingly, the Supreme Court of North Carolina held that the insured’s losses from the shutdown orders were excluded, as “a reasonable person in the position of the insured would understand the viral contamination exclusion in Cato’s policy to exclude Cato’s alleged losses.”

North State Deli is contrary to the great weight of authority across the country, including the Supreme Court of Pennsylvania’s decision in Ungarean v. CNA & Valley Forge Ins. Co., 323 A.3d 593 (Pa. 2024). Unlike the Supreme Court of North Carolina, most courts in the country have held that losses caused by shutdown orders issued in respond to the COVID‑19 pandemic do not qualify as “direct physical loss or damage” to property that qualifies for coverage under commercial insurance policies.