More Important First Party Property Exclusions

Applicable in Almost Every Property Policy

Loss or Shortage Disclosed on Inventory

The “mysterious disappearance” exclusion is often paired with, or followed by, an exclusion for loss or shortage disclosed on taking an inventory because of the similarity of moral hazard raised by losses either unknown or not discovered until an inventory is taken. The inventory shortage exclusion is often misunderstood and misapplied. The exclusion, in simple, clear and unambiguous language states: “This policy does not insure against … [l]oss or shortage disclosed upon taking inventory.”

In Betco Scaffolds Company, Inc. v. Houston United Casualty Insurance Company, 29 S.W. 3d 341, 29 S.W. 3d 341 (Tex. App. 10/12/2000), the Texas Court of Appeal stated that its ruling was one of first impression in Texas. Betco reported two thefts to the local police and to its insurer far below the policy’s $25,000 theft deductible. It was not until the annual physical inventory was performed that Betco claimed a loss of approximately $160,000. Although Betco attributed the physical inventory shortage to the two burglaries Betco presented no evidence to support such an inference.

The court, reviewing all of the facts in a way most favorable to the insured, found:

Although Betco seeks to attribute the September shortage to the two burglaries, it presented no evidence to support any such inference. On the contrary, Betco’s loss prevention manager admitted that he did not have even the capability to determine whether any of the items discovered missing in the September inventory could have been taken in the burglaries. In theory, some or all of the September shortage could have instead resulted from a variety of other causes, as outlined above, which: (a) could have occurred before and/or after the burglaries; (b) might or might not have involved an actual physical loss from an identifiable external cause; and (c) would be difficult or impossible to ever identify with reasonable certainty.

As illustrated by the circumstances of this case, and contrary to the rationale of Betty [Betty v. Liverpool & London, 310 F. 2d 308 (4th Circuit, 1962)], we believe that the inventory exclusion provision reflects a recognition of the inherent uncertainty as to the causes of shortages which are only disclosed upon taking a periodic physical inventory. We further believe that the inventory exclusion provision (like a proof of loss provision) reflects a recognition that an insurer should be afforded a fair opportunity to: (i) investigate the circumstances of a claim before circumstances change and memories fade, and (ii) where, as here, a theft is alleged, attempt recovery of the stolen items. The fact that an insurer can be held liable for failing to reasonably investigate a claim, as Betco has alleged, further underscores the need to allow an insurer’s investigation to be made while the greatest likelihood exists to collect meaningful information. The passage of time and occurrence of intervening events can only operate to obscure relevant facts and defeat these objectives.

In Betty v. Liverpool & London & Globe Ins. Co., 310 F.2d 308 (4th Cir.1962) the rule limits the “inventory exclusion” clause in an all-risk policy to cases in which a plaintiff seeks to establish a “loss” by comparing inventory calculations and then equating an inventory shortage to a “loss” covered by the policy without any evidence of loss other than such inventory calculations. As observed in Betty: ‘It would be both reasonable and fair for an insurer to except itself from a loss or shortage reflected solely on the insured’s books and not substantiated by any independent external proof—a mere theoretical inventory loss.’”[1]

Based on what the court perceived to be the overall intent of the policy and the plain meaning and rationale of the inventory exclusion clause, it concluded that the inventory shortage provision expressly allocates to the insured the risk of a loss or shortage which comes to the attention of the insured solely by reason of taking a regularly scheduled, that is, periodic, physical inventory. The court recognized that a regularly scheduled inventory could coincide with the investigation of a casualty in such a way that the inventory is intended by the insured as a means to quantify the loss. In that event, the inventory exclusion provision would not exclude the loss because the loss would not have been disclosed upon taking inventory.

In Meyer Jewelry Co. v. Gen. Ins. Co. of Am. 422 S.W.2d 617 (Mo.1968), the Missouri Supreme Court held that the inventory shortage exclusion clause did not exclude inventory computations which would tend to prove the amount of the plaintiff’s loss where independent evidence first showed that an employee had stolen items from the plaintiff’s merchandise inventory.[2]

The inventory exclusion provision reflects a recognition of the inherent uncertainty as to the causes of shortages which are only disclosed upon taking a periodic physical inventory. Courts would believe that the inventory exclusion provision (like a proof of loss provision) reflects a recognition that an insurer should be afforded a fair opportunity to:

(i)      investigate the circumstances of a claim before circumstances change and memories fade, and

(ii)    where, as here, a theft is alleged, attempt recovery of the stolen items.

(iii)  The fact that an insurer can be held liable for failing to reasonably investigate a claim, further underscores the need to allow an insurer’s investigation to be made while the greatest likelihood exists to collect meaningful information.

(iv)   The passage of time and occurrence of intervening events can only operate to obscure relevant facts and defeat these objectives.”[3]

A regularly scheduled inventory could coincide with the investigation of a casualty in such a way that the inventory is intended by the insured as a means to quantify the loss. In that event, the inventory exclusion provision would not exclude the loss because the loss would not have been disclosed upon taking inventory.[4] Of course, the inventory must be taken honestly to show what inventory actually exists in the facility.

In New York, deciding a case where the “inventory shortage” exclusion had been removed, the court stated:

The excess insurers’ argument is grounded in the assertion that Simplex does not know how the alleged shortage occurred, if the shortage of all units occurred in the same manner, whether any single person or multiple individuals were responsible for the loss, the number of occurrences, where the units disappeared, and how many units disappeared at one time. This is undisputed.

Despite an extensive investigation over the course of several years, the details as to how and when the jewelry found missing at the taking of inventory came to be lost is still unknown. That circumstance, however, is no defense to Simplex’s claim. The loss, notwithstanding that it is “unexplained” and “mysterious,” is the very risk that the insurers agreed to cover when the original condition (M), which excepted such loss from coverage, was deleted and replaced by the endorsement known as “Clause 5 (Conditions) M.” The latter covers “goods missing at stock-taking” as long as notice of the claim has been previously given. As already indicated, notice of the possibility of an inventory loss was given here and the excess insurers do not claim otherwise. As a matter of fact, the insurers acted on such notice and engaged an adjuster to investigate the matter. Simplexdiam, Inc. v. Brockbank, 283 A.D. 2d 34, 727 N.Y.S. 2d 64 (N.Y. App. Div. 06/05/2001).

The excess insurers’ argument in Simplexdiam that, in cases of unexplained loss or mysterious disappearance, the burden is on the insured to identify the number of occurrences and the amount of loss per occurrence found no support in the precedents. The Supreme Court, Appellate Division found that were such an argument accepted, it would render coverage for such risks as unexplained loss, mysterious disappearance, or inventory shortage for the most part illusory. Had the exclusion not been deleted the insurers should have had no difficulty avoiding payment but, since they specifically insured the risk, the court properly held the insurers to their promise.

Courts have upheld the application of this type of “mysterious disappearance” exclusion. See, e.g., Maurice Goldman & Sons, Inc. v. Hanover Ins. Co., 607 N.E.2d 792 (N.Y. App. 1992) (holding that an exclusion for “unexplained loss,” “mysterious disappearance,” and “loss or shortage discovered on taking inventory,” was unambiguous and applied to exclude jewelry loss where insured’s president could not say how or where loss occurred).

Insurers and courts must understand that unscrupulous jewelers, furriers or sellers of high value property may decide to not remove from a perpetual inventory items sold for cash. By leaving the item in inventory, by not reporting the sale as income, money can be saved on income taxes. A jewelry store’s inventory records could show millions in inventory when most of the inventory had been sold for cash and the display cabinets were empty at the time of the loss. This type of insurance fraud is difficult to discover and can only be defeated with a thorough investigation and analysis of the insured’s sales and inventory methodology.

I once worked on a case where an insured retained a public adjuster before a loss who created a complete bookkeeping system and inventory showing more than $500,000 in inventory backed up with multiple consignment agreements all of which turned out to be fraudulent. After creating the records, the insured opened a retail store and bought a jewelers block policy with a $500,000 limit, waited just before the first installment on the premium finance contract was due and reported an armed robbery and a total loss. The claim was defeated because, at examination under oath, the insured admitted the fraud.

There is no merit in an insured’s contention that the language “such as shortage disclosed on taking inventory” should be read as a limitation of the policy exclusion’s scope. The use of the introductory phrase “such as” indicates unambiguously that the reference was intended as an example of a situation in which “there is no physical evidence to show what happened to [the property],” not to limit the scope of the exclusion to shortages discovered during the taking of inventory. It would make no sense to exclude from coverage an unexplained loss discovered upon a formal taking of inventory while allowing coverage for an unexplained loss discovered in the course of other activities. [Westcom Corporation v. Greater New York Mutual Insurance Company, 41 A.D.3d 224, 839 N.Y.S.2d 19, 2007 NY Slip Op 5336 (N.Y. App. Div., 2007)]

Special Form Exclusions

Insurance protects against risks, not certainties. The term “risk” does not cover inherent vice or mere wear and tear. The fortuity requirement is a necessary element of the concept of risk. The definition of fortuity, given in Restatement of Contracts section 291 comment a, provides:

A fortuitous event . . . is an event which so far as the parties to the contract are aware, is dependent on chance. It may be beyond the power of any human being to bring the event to pass; it may be within the control of third persons; it may even be a past event, such as the loss of a vessel, provided that the fact is unknown to the parties. (Emphasis added).