Table of Contents 

The endorsemennt hints that one of its primary targets is cases where tenants manufacture methamphetamine.

Risk Management

Risks from tenants' questionable activities

New ISO endorsement excludes losses from renters' "by-products"

By Donald S. Malecki, CPCU

To  the extent that owners of commercial  rental properties read their policies, one wonders whether they will grasp the meaning of a new endorsement introduced by ISO titled Exclusion of Loss Due To By-Products of Production or Processing Operations (Rental Properties) CP 10 34.

Earmarked for official use beginning in October 2013 in most jurisdictions, this endorsement is targeted to apply to the Building and Personal Property Coverage Form; Business Income (and Extra Expense) Coverage Form; Business Income (without Extra Expense) Coverage Form; Extra Expense Coverage Form; and Standard Property Policy.

This endorsement has a schedule that requires the premises address and building number, along with a description of the rental unit. Specifically excluded is loss or damage to the described premises caused by or resulting from "smoke, vapor, gas or any substance released in the course of production operations or processing operations performed at the rental unit(s) described in the Schedule."

The endorsement's exclusion applies regardless of whether the operations are legally permitted or prohibited; permitted or prohibited under the terms of the lease; or usual to the intended occupancy of the premises. It also excludes any indirect loss, such as loss of business income and extra expenses.

This exclusion, however, does not apply to loss or damage by fire or explosion that might result from the release of a by-product of the production or processing operation.

The idea behind this new exclusion is to preclude coverage that owners of rental properties have sought over the years for damage that tenants (lessees) have caused to the rental property based on the tenants' occupancy that is viewed as a business risk, i.e., not insurable.

The endorsement does not say so directly, but it does give some hint that one of its primary targets is those cases where tenants conduct operations where they manufacture methamphetamine (meth), which can get messy—too mild a word based on the resulting damage.

Cases for coverage 

Many of the cases have dealt with damage to rental houses as opposed to apartment houses, but the exposures and results are the same. A case in point is Largent v. State Farm Fire & Casualty Company, 842 P.2d 445 (Ct. App. OR 1992), where the owner of a home brought a claim under his property policy when his home was damaged as the result of the operation of an illegal methamphetamine laboratory (meth lab).

The policy excluded coverage for accidental direct physical losses "consisting of, or directly and immediately caused by, . . . wear and tear; deterioration, inherent vice; latent defect; mechanical breakdown; rust; mold; wet or dry rot; contamination; smog; smoke from agricultural smudging or industrial operations. . . ." The central issue was that coverage of damage from the illegal meth lab was excluded as "contamination."

The evidence at trial was said to have been in some conflict on the precise method by which the meth was "cooked," thereby damaging the property. However, it was said to have been uniformly to the effect that the heating and chemical reaction processes resulted in the discharge of airborne vapor and particulates.

The insurer explained that an argument could be made that when chemicals from the production of meth permeate porous materials, such as drapes, carpets, walls and woodwork, the damage caused thereby constitutes an "accidental direct physical loss." However, such loss, the insurer added, consisted of or was caused by contamination.

The homeowner responded, in effect, that the contamination exclusion did not apply to sudden damage, such as that resulting from the discharge of smoke or vapor, even if residual contamination ensued. Rather, the homeowner asserted, the exclusion applied only when contamination happens over time and is an independent direct source of loss. The homeowner analogized contamination to other causes of loss listed in the exclusion, such as wear and tear.

Another argument raised by the homeowner was that the insurer's rationale for denying coverage would eviscerate virtually all coverage because many, if not most, events that were clearly covered, e.g., smoke, fire and explosion, result in chemical byproducts and contamination.

The court agreed with the homeowner. Reading the policy as a whole, the court said, the logical meaning of the exclusion was the one the homeowner offered, rather than the insurer's position, which would have negated much of the policy's primary coverage.

In Shaffer v. State Farm Fire & Casualty Company, 852 P.2d 245 (Ct. App. OR. 1993), the primary issue was whether the exclusion for contamination applied to any claimed damages resulting from the production of meth on the premises owned by the named insured. The homeowner took the position that the production technique produced "smoke," which was a covered loss under the policy.

The insurer maintained that the meth process involved chemical reactions, not the burning of any materials or release of any particulates carried aloft.

The court, however, stated that the exclusion for contamination did not apply to damages resulting from the use of the home as a meth lab. The characterization of the damages as "smoke," rather than as "vapors," was inconsequential

Gaff v. Allstate Insurance Company, 54 P.3d 1266 (Ct. App. Wash. 2002) is another case where the insurer denied coverage to a homeowner whose rental property was damaged through a tenant's operation of a meth lab. In this case coverage was denied on the basis of contamination.

Interestingly, the court ruled for coverage on the basis of the covered cause of loss of vandalism. The reason was that the tenants were said to have acted with conscious or intentional disregard for her property rights and that their acts, therefore, were vandalism.

Insurer wins a case

Despite the introduction of a specific exclusion, not all cases are lost by insurers. One such case in this category is Tualatin Valley Housing Partners v. Truck Insurance Exchange, 144 P.3d 991 (Ct. App. OR 2006)—an insurance dispute over damage to an apartment owner's building resulting from a tenant's manufacture of meth.

The insurer denied coverage based on an exclusion for damage arising out of dishonest or criminal acts committed by anyone with an interest in the property, including tenants. The property owner argued that the exclusion for criminal acts did not apply because tenants as a rule do not have an interest in rented premises and because in any event the meth in question was produced without the knowledge or cooperation of the actual tenant.

A considerable amount of the dialogue between the parties was over the meaning of the term "interest," which was not defined in the policy. With the "ordinary" meaning of the word "interest" supporting the insurer's reading, the court held that the dishonesty or criminal acts exclusion applied to tenants and not solely to persons with an ownership interest in property.

Fire as a covered cause 

Operation of a meth lab is not the only problem that can confront the owner of rental property. The case of Kochendorfer v. Metropolitan Property & Casualty Co., Case No. C11-1162-MAT (U.S. Dist. Ct. W.D. Wash. 2012) arose after tenants renting a house "jumped" the electrical panel, tapping into power to operate and conceal a marijuana growing operation.

The tenants' tampering with the electrical panel caused a fire that also resulted in the owner's loss of rents. The insurer did not deny the existence of coverage for some of the loss of use. The conclusion was that coverage was found to apply to loss of rents, code upgrade, and cleanup and remediation costs.

Moonshine operation

The way the new ISO exclusion is worded, it could conceivably apply to moonshine operations, which may not be as popular today as meth labs. Even though Prohibition ended in 1933, some people apparently still have a preference for their own concoction or perhaps simply enjoy engaging in an occupation where the payment of taxes can be avoided.

One old case is Livaditis v. American Casualty Co. of Reading, Pa., 160 S.E. 2d 449 (Ct. App. GA. 1968), where the owner discovered his leased house was being used for the manufacture of moonshine liquor. The trial court found in favor of the insurer, and the homeowner (insured) appealed.

The tenant in this case had been given permission to erect an addition to the house. He built a lean-to across the back in which the moonshine still was housed, then vented the "contraption" so that the smoke, fumes and vapor were pulled by a fan to the interior of the house.

As a result of smoke and condensation, the paint in the rooms peeled; plaster was loosened; rugs, drapes and walls were stained, soiled and covered with mold. The outside walls were charred by fire. The swimming pool adjacent to the house was used as a dump for mash and was stained and broken.

According to the court, although recovery was possible as a vandalism loss, i.e., the intentional destruction of property caused by tenants for illegal purposes, the homeowner did not prevail in light of breach of a policy condition. Specifically, the homeowner (named insured) did not bring an action within 12 months of the inception of a loss.

Conclusion

Barring only the "moonshine" case in Georgia, it is interesting to note that most of the rental residential cases involving meth labs have taken place in the northwestern states of Oregon and Washington. Why that is, is uncertain.

While most of the cases thus far appear to have dealt with rental property of homeowners, apartment rentals also are likely to be candidates for such illegal operations as methamphetamine laboratories, if not more so than residential homes. It does not matter, however, whether the operation produces "smoke" or "vapor"; both causes are excluded.

Whether owners/lessors of apartment houses will understand the nature of this new exclusion to be issued for eligible risks of the building and personal property coverage form, CP 10 34, when it is raised following a claim remains to be seen.

It is easy to say that owners of rental property need to exercise care when renting their properties, but making sure these kinds of illegal operations are not undertaken can be difficult, since there are other potential violations that owners need to heed if they are to stay out of trouble with the law in the rental process.

It will also be interesting to see what kind of challenges are raised in light of this new exclusion and what other policy provisions are raised to counteract the application of this new one. One good thing about this new endorsement is that comes free of charge.

The author

Donald S. Malecki, CPCU, has spent more than 50 years in the insurance and risk management consulting business. During his career he was a supervising casualty underwriter for a large Eastern insurer, as well as a broker. He currently is a principal of Malecki Deimling Nielander & Associates LLC, an insurance, risk, and management consulting business headquartered in Erlanger, Kentucky.

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