Exclusion of Viral Contamination Bars Coverage Despite Direct Physical Loss Allegations

Introduction

The Supreme Court of North Carolina’s decision in Cato Corp. v. Zurich American Insurance Co., No. 353PA23 (Dec. 13, 2024), addresses a pivotal issue in commercial property insurance—whether an “all-risk” policy covers losses alleged to be caused by the COVID-19 virus when the policy contains a viral contamination exclusion. Cato Corporation, a national clothing retailer with more than 1,300 stores, sued its insurer, Zurich American Insurance Company, after government shutdown orders and the physical presence of the COVID-19 virus allegedly forced store closures, reconfigurations, and remediation expenses. Zurich denied coverage based on a policy exclusion for “contamination,” defined to include viruses. The trial court and Court of Appeals dismissed Cato’s complaint under Rule 12(b)(6). On discretionary review, the North Carolina Supreme Court affirmed—but clarified its reasoning—holding that while Cato had alleged a “direct physical loss of or damage” to property under its policy, the explicit viral contamination exclusion unambiguously bars coverage for the alleged losses.

Summary of the Judgment

Relying on its companion decision in North State Deli, LLC v. Cincinnati Insurance Co., No. 225PA21-2 (Dec. 13, 2024), the Court reaffirmed that an “all-risk” policy’s operative grant of coverage for “direct physical loss of or damage” does not require tangible alteration of property. Cato’s factual allegations—that the COVID-19 virus “physically inundated” its stores, transformed air and surfaces into disease vectors, rendered premises unsafe, and triggered government‐ordered closures and reconfigurations—were sufficient, at the motion‐to‐dismiss stage, to allege a “direct physical loss of or damage.” However, the Court held that once coverage was prima facie established, Zurich met its burden of proving the “contamination” exclusion applied. The policy defined “contamination” as “any condition of property due to the actual presence of any … virus,” and excluded all costs associated with it, including inability to use or occupy. The Court rejected Cato’s attempt to invoke a Louisiana amendatory endorsement to override the exclusion, finding that state‐specific endorsements apply only to risks in those states. Concluding that a reasonable insured would understand the exclusion to bar Cato’s COVID-related claims, the Court affirmed the dismissal of Cato’s complaint.

Analysis

Precedents Cited

1. North State Deli, LLC v. Cincinnati Insurance Co. (No. 225PA21-2): Decided the same day, this companion case established that “direct physical loss” under an “all-risk” commercial property policy need not involve tangible alteration of the insured premises. The Court applied ordinary meaning, construed “direct physical loss” broadly, and declined to read into the term a requirement of structural damage. This precedent controlled the threshold coverage analysis in Cato.

2. Uncork & Create LLC v. Cincinnati Insurance Co., 498 F. Supp. 3d 878 (S.D.W. Va. 2020), aff’d, 27 F.4th 926 (4th Cir. 2022): Federal decisions requiring “tangible alteration” influenced the Court of Appeals’ earlier ruling but were expressly disavowed by the Supreme Court in both North State Deli and Cato.

3. Fortune Insurance Co. v. Owens, 351 N.C. 424 (2000): Established the two-step burden of proof in coverage litigation: (a) the insured’s prima facie showing that the loss falls within the policy’s grant, and (b) the insurer’s burden to prove a policy exclusion applies.

4. State ex rel. Stein v. Kinston Charter Academy, 379 N.C. 560 (2021), and other procedural authorities on Rule 12(b)(6): Confirmed that well-pleaded factual allegations are accepted as true at the pleading stage and that dismissal is proper only if the plaintiff would have no relief under any provable facts.

Legal Reasoning

The Court applied North State Deli’s interpretive framework to Cato’s policy. Because the policy expressly insured “against direct physical loss of or damage” without defining “direct physical loss,” the Court gave the phrase its ordinary meaning, recognizing that the conjunctive “or” requires a distinct meaning for “loss” versus “damage.” Cato’s allegations of virus presence, unsafe conditions, and government orders triggered coverage under that broad reading. Turning to exclusions, the Court reiterated the insurer’s burden to prove them once coverage is prima facie shown. The policy’s plain language defined “contamination” to include the presence of viruses and excluded all associated costs, including inability to use or occupy. The Court refused to rewrite the contract to read out that exclusion based on an inapplicable state-specific endorsement. It harmonized the thirty-one endorsements by reading each to apply to policies insuring risks in the state named in its title, avoiding internal conflicts and giving every provision effect.

Impact

This decision has significant implications for commercial property policyholders and insurers:

• Affirms that “direct physical loss” coverage is broader than physical structural damage, ensuring policyholders can plead coverage for losses caused by novel or intangible hazards.
• Reinforces the critical importance of exclusionary language: explicit viral or contamination exclusions will bar coverage for pandemic-related claims, even when “all-risk” policies are at issue.
• Clarifies the treatment of state-specific endorsements: titles matter, and endorsements apply only to the state named, barring insureds from cherry-picking favorable state forms not negotiated for their risk locations.
• Guides future litigation: insurers must expressly exclude emerging risks, and policyholders must closely track all endorsements and exclusions across jurisdictions.

Complex Concepts Simplified

“All-risk” Policy: An insurance policy that covers all causes of loss except those the policy explicitly excludes. The policyholder bears the burden of identifying applicable exclusions.

Direct Physical Loss of or Damage: A catch-all phrase in many property policies. “Direct physical loss” may encompass intangible or functional losses (e.g., inability to use premises), while “damage” typically refers to tangible harm.

Contamination Exclusion: A clause excluding coverage for any loss or cost resulting from the presence of a contaminant—here, explicitly defining a contaminant to include viruses. Once an insured alleges a loss, the insurer must show the exclusion applies to defeat coverage.

Amendatory Endorsement: A policy attachment that modifies the base form. State-specific endorsements amend the policy only for risks located in that state; they do not override coverage for risks elsewhere.

Conclusion

Cato Corp. v. Zurich American Insurance Co. confirms the broadened scope of “direct physical loss” under North Carolina law but reminds policyholders that precise exclusionary language can decisively shape coverage outcomes. Insurers should draft pandemic and emerging‐hazard exclusions clearly, and policyholders must vigilantly review all policy forms and endorsements. This decision harmonizes coverage principles with contract interpretation rules and sets a clear precedent for handling virus-related property claims in North Carolina.