Author: VU Faculty
The Special Causes of Loss form (and most crime forms) excludes losses "where the only evidence of the loss or damage is a shortage disclosed on taking inventory." In other words, if you conduct an inventory and find something missing, that doesn't necessarily mean it was stolen. But what DOES it mean? In this article, we'll discuss how this exclusion should be applied and what the courts have said about it.
"One of our commercial insureds has experienced a loss which the carrier is about to deny. An employee of the insured noticed some inventory missing upon his entry into their storage warehouse on Monday morning. The insured reported this to us as well as the police as a theft or possible employee dishonesty due to no signs of unauthorized entry. Our insured then takes an inventory to determine the exact quantity of product that is missing.
"The inventory needed to include the warehouse as well as store location as all is run together for the two separate buildings. Upon taking the inventory the insured determined a quantity of 40 items had been taken. They further discovered that 36 items were missing from the store location. Insurer is going to deny the portion of the claim involving the store due to limitation C e. in the Special Causes of Loss Form CP 10 30 10 00.
"This limitation refers to "Property that is missing, where the only evidence of the loss is a shortage disclosed on taking inventory, or other instances where there is no physical evidence to show what happened to the property."
"Please be aware that insured had completed a semi-annual physical inventory three weeks prior to the claim. Insurer contends that the employee noticing the missing inventory is sufficient physical evidence to enact the claim at the warehouse but because the inventory they did was why the missing product was discovered in the store they are indicating no coverage due to the limitation mentioned above.
"Our contention is that the limitation they are referring to would appropriately be used if for example the shortage was realized after their regularly scheduled semi-annual inventory and not be used for an inventory taken specifically to accurately determine a count after a known loss to their warehouse. It is our belief that the two are actually related. Insured indicates their regular inventory counts only show one or two missing items and this instance involved 36 items since count just three weeks prior.
"We further contend that the insured would have noticed the missing inventory in their routine course of business at the store location just like they did at the warehouse and then there would be no question of coverage. Please advise your thoughts. Thank You."
This exclusion has been around, as best as we can tell, since at least 1957 and is found in both property and crime forms. The purpose of the exclusion is to preclude coverage for theft losses where the ONLY evidence is via an inventory. In high school I worked at a grocery store and we took inventory every Saturday night. We compared sales receipts and physical shelf inventory to delivered goods. In the vast majority of cases where there was a discrepancy, it was a shortage.
However, just because goods are missing doesn't necessarily mean they were stolen. Sometimes it was a mathematical error in county incoming merchandise and/or shelf stock. In many cases, it involved damaged merchandise such as the jar of pickles that was dropped and broken but never noted on the inventory. So, if the only evidence you have of missing property is that shown via inventory calculation, that is insufficient to trigger theft coverage under the policy.
There must be some sort of corroborating evidence that is physical in nature. Evidence of forced entry would be one example, but the policy language does not require such evidence. In our opinion, an employee's observation that property had been in one specific place and time, but is now missing MIGHT be physical evidence.
According to the International Risk Management Institute (IRMI) analysis of this exclusion, "Physical evidence need not be limited to evidence of forced entry. The fact that the missing property was known to be at a particular place last night but is gone this morning, would, under some circumstances, constitute physical evidence of theft. Evidence of forced entry is not necessarily required. If that were the intent, the form drafters had every opportunity to say so plainly."
The use of inventory records is not entirely precluded from the claim process. An analysis of inventory records, while not evidence of theft in and of themselves, can be instrumental in determining the amount of the loss. If someone notices that a number of items have been taken, but can't confirm how many, then an inventory can serve as one tool to determine that.
A number of courts have looked at this issue, usually in crime forms. In addition to a couple of cases cited in the IRMI analysis referenced above, below are several others. Following these citations are several comments from the VU faculty, including an important one about employee dishonesty.
Strings & Things in Memphis, Inc. v. State Auto Insurance Companies, Tennessee Court of Appeals (1995). "The evidence showing the purchase of the individual items and the absence of these items from inventory without evidence of a sale is not an inventory computation as contemplated by the policy."
Ace Wire & Cable Co., Inc. v. Aetna Casualty & Surety Co., 457 N.E.2d 761 (1983). "We hold that the phrase 'inventory computation' is to be construed to proscribe proof of the fact or amount of loss through a generalized estimate, calculated, for example, from sales records and average markup, of what the dollar value of inventory on hand should be. It does not, however, preclude proof of the fact or amount of loss through inventory records (whether perpetual or periodically made) detailing the actual physical count of individually identifiable units such as are described...."
Popeo v. Liberty Mutual Ins. Co., 369 Mass. 781, 785, 343 N.E.2d 417. "Where the missing items are identified from such records, it has been held that there is no 'inventory computation' within the meaning of the inventory exclusion clause."
Paramount Paper Products Co. v. Aetna Casualty & Surety Co., 182 Neb. 828, 839, 157 N.W.2d 763. "The exclusionary clause does not bar an inventory made upon a unit basis, but does bar inventories which require computation to reduce them to some other basis, or, where when one inventory is compared with a later one, it is necessary to compute and allow for sales and purchases made in the interim. Inventory that is simply a list of materials amount to enumeration, not inventory calculation, and is not barred by exclusion provision."
New York University v. Continental Insurance Company, 87 N.Y.2d 308, 662 N.E.2d 763, 639 N.Y.S.2d 283 (1995). "[T]he insured will be indemnified for the actual losses timely discovered, while the insurer will be protected from indemnifying the insured for losses that may accumulate to excessive amounts over a period of years, and which can be proven only by estimation."
Reedy Industries, Inc. v. Hartford Insurance Company of Illinois, 306 Ill. App. 3d 989, 715 N.E.2d 728 (1999). "It is incumbent upon Reedy, as the insured, to come forward with some evidence that its claim falls within the terms of the policy. However, it is Hartford's burden to show that a claim falls within a policy provision limiting or excluding coverage. The exclusion was designed to curb abuses by employers against employee dishonesty where covered losses were claimed on the basis of mere estimates, but where losses might actually be the result of bookkeeping errors, waste, or negligence."
Tri-Motors Sales, Inc. v. Travelers Indemnity Company, 19 Wis. 2d 99, 106, 119 N.W.2d 327, 331 (1963). "When an insured makes a claim for a loss based on employee dishonesty, inventory computations that tend to prove the amount of an insured's loss are not excludable under the terms of a policy where 'independent evidence first shows' the dishonest acts.
Did this insured have electronic inventory controls? Can they reconstruct their order/sales records? With the employee walking into the warehouse on Monday morning and noticing missing items, apparently they were either (a) large, (b) expensive, or (c) both. I think this falls outside the "loss identified by inventory" exclusion. If a salesman at a Cadillac dealership walks in on Monday and sees all the 2003 Cadillacs are missing, are they excluded? If they walk into the parts area and notice ten short block engines are missing, are they excluded?
This one could go either way, but the most likely place is to court. The biggest problem here is not whether a theft occurred...it looks to me like theft is likely. The question is WHO was the thief? The Special form excludes employee dishonesty. If it's likely that an employee was involved in the theft (which would be more likely without evidence of forced entry), then there is no coverage. Of course, it could be possible that an entry was left unlocked and unattended and someone stole the property. These are all questions of fact and a jury will have to decide that.
I can see an argument either way. However, an exclusion is being applied, so the burden is on the carrier. I think it's likely that a theft occurred, the main question being whether is was employee dishonesty or third-party theft. The worse "inventory shortage" denials I've ever seen was for a trout ranch insured who bought 21 tractors for use around his ponds at several locations. One morning he discovered that the two at one location were gone. The adjuster cited this exclusion as a basis to deny the claim. Come on.
I'm going to have to disagree with the carrier on this one. The "inventory shortage" exclusion only applies if the occurrence is discovered during the inventory. If there is a discovery of a loss and then an inventory must be done to determine the total amount of the loss, then coverage exists. The inventory was done after the loss was discovered which determined the ultimate amount of the loss. It doesn't matter that additional inventory was discovered to be missing...all that matters is that the occurrence was discovered FIRST. Of course, all this assumes that it wasn't an employee that did it...that's excluded.
In your recent commercial question, you dealt with the "Theft 'Inventory Shortage' Exclusion."
Through 1988, the language in that exclusion was somewhat different. When it was changed, it seemed to me to separate the second half of the exclusion from losses disclosed upon taking inventory. Have there been legal cases which commented on what might be "other instances where there is no physical evidence to show what happened to the property?" When ISO changed the language, did they make their intent clear?
It seems unlikely that it was meant to bolster the "dishonest or criminal acts" exclusion to make a stronger employee dishonesty combination. The dishonest acts exclusion doesn't even bother to go beyond property entrusted to employees.
I was about ready to accept that, since the warehouse and store inventories were run together, the carrier might be compelled to inventory both, deduct for shrinkage, then accept the other missing items as a part of this presumed warehouse theft.
But then the questioner said the insured "further discovered that 36 items were missing from the store location." If the inventory for both locations was "run together," how could the insured know that 36 items were missing from the store? IF the records are separable enough to allow the insured to reach this conclusion, I don't know that the carrier would be compelled to accept shortages from the store as a part of the warehouse theft.
Perhaps the question was posed imprecisely, but I think there is enough unanswered as the question is posed to lead to the possibility that the carrier's position was correct.
By the way, I agree with the carrier's initial decision. We have the obligation of proving the applicability of our exclusionary language. Could we conclusively prove that the evidence that the goods were discovered to be missing from a known place is not "physical" evidence? Probably not. It does involve a change in the physical condition of property. The acknowledgement of coverage for the loss from the warehouse seems proper.
Would the carrier have to extend that coverage to other buildings, not known to have been subjected to theft? No. (If a Wal-Mart in Ames, IA discovered that ping-pong paddles had apparently been stolen from their storage area, we would not invite an international inventory of all Wal-Mart locations to determine the count of stolen ping-pong paddles.) If the only evidence of theft from the store was an inventory of goods, I would agree with the carrier's entire decision. "Yes" on the warehouse loss - "no" on the retail loss.
I was under the impression from the writer's question, however, that the only way of measuring the theft loss from the warehouse was to inventory both locations, since their records were not separately maintained. If that were the case, I would probably agree with the writer. What threw me, however, was that the inventory did establish the quantity of goods lost from the warehouse and separately establish the quantity of goods lost from the retail outlet. That does not seem possible under the original set of facts laid out by the writer.
The answer should probably have been conditional. We should accept that a theft loss occurred at the warehouse. We should accept that an inventory might have to be done to establish the exact amount of loss from the warehouse. If it was impossible to separately measure the warehouse loss because the only inventory combined warehouse and retail stock, we would have to use that inventory to establish the amount of the warehouse loss.
If, however, the records were maintained in a manner which allowed us to separate the warehouse stock from the retail stock, so that we could tell, for instance, that 40 items had been taken from the warehouse and another 36 from the retail outlet, we should pay for the warehouse loss (physical evidence of theft), but not the retail shortage (strictly inventory evidence of shortage).
If the agency wished to use its arguments about recent pre-loss inventories to argue the logic that the shortage in the store must be connected to the theft in the warehouse, it could try to convince the carrier that it should not strictly employ the exclusionary language as written - but that would call for a general business decision rather than a decision of policy interpretation.
If it is demonstrated that losses occurred from both locations, that would increase the possibility of employee involvement. (How many people would have access to both locations?) Still, the employee dishonesty language is not strong here. Not only would we have to prove it (exclusionary language), but the only goods to which the exclusion applies are properties entrusted to the dishonest employee(s).
George Sullivan
The Hartford.
Excellent points, George. I polled our faculty but no one really had any info on ISO's intent when the change was made. The points you make are well taken and often we have to make some assumptions about the questions.
I think the carrier, in this specific case, is probably right since this is a property, rather than crime, claim. The court cases I cite in the article dealt with employee dishonesty cases under crime forms or fidelity bonds. I used them since they addressed the specific issue of the role of inventories in determining if a theft had occurred.
Based on the limited information provided, this has the appearance of being a theft rather than inventory shortage (there was a pile of stuff there one day and gone the next, as confirmed by the inventory). Most likely a theft did occur, but the issue is whether the theft was committed by an employee or third party.
If the former, then there's no coverage. If the latter, then there probably is coverage. Since these are questions of fact, unless the parties can reach agreement, I don't know of any way to resolve the claim other than arbitration or, more likely, litigation. If that happens then it will, most likely, take more evidence (even circumstantial) than an inventory confirmation of a loss.
As always, thanks for the feedback...it's nice to know people read this stuff and that we insurance geeks aren't alone in the world. :-)
Last Updated: February 26, 2010