Do I have to re-build? What if I don’t? and “What is actual cash value?”
By Michael C. Perlmuter, JD, President & General Counsel
One of the most frequently asked questions when assisting a business or residential property owner in adjusting a property insurance loss is: “What are my options for an insurance claim recovery from this loss?”
The question, though simple, is complex in nature and thus becomes the driver for most property owners to retain a public insurance claims adjuster, read Alex N. Sill Company, when contending with an insurance loss.
Policy owners acting on their own encounter a process akin to a notorious sidewalk shell game. In this instance, the policy owner is entranced by the sleight of hand action on the corner of Betternot Boulevard and Aboutobetaken Avenue trying to guess which of the five mollusks holds the winning answer. The reality is that each of the shells merely contains a possible solution, but none are optimal as the game is hosted by an insurance company magician trained to minimize payouts.
The potential barriers for maximizing a recovery start right up front, beginning with defining the coverage, meandering through the non-committal language and then being held to the scrutiny of the state in which the policy is enforced.
Let’s begin with the type of coverage. Every insurance policy essentially states the same message — that the insurer shall make payment on a property loss to an insured based on the “actual cash value” of the property. But what is the true meaning of actual cash value (ACV)?
For those policies that contain “replacement” language or so-called “Replacement Policies,” an insured is entitled to recovery of the “withheld depreciation” when the property is re-built, replaced or repaired with “like kind materials, etc.” (It is a common misunderstanding of many policyholders that just because they have a Replacement Policy, they are entitled to the replacement cost of their property when the property is damaged.) In fact, an insured is not entitled to their replacement cost until and unless the property is re-built, replaced or repaired. Moreover, the re-build or replacement must be done with “like kind” materials etc.
►Read my blog entitled “Replacement Cost Insurance– What You Don’t Know Can Hurt You” published January 13, 2017 and look for a future blog about like kind material replacement.
Assuming the insured has a Replacement Policy, What Are His or Her Options?
Certainly, one option is not to re-build, replace or repair the damage to the real or personal property.
Then what?
In accordance with the insurance policy, the insured is entitled to payment of the ACV of the loss.
Seems simple enough, right? Wrong!
The problem in most cases and in most insurance policies, the term “actual cash value” is never defined, thereby leaving it up to “interpretation” of the insurer, the insured and quite often, the courts of each state — because all insurance is state regulated and each state can have its own definition of ACV. Thus, it is likely an insured who doesn’t wish to re-build, repair or replace can’t understand the options should the choice be to not re-build, unless he or she is familiar with the case law of a particular jurisdiction.
The issue of defining ACV literally (quoting my daughters’ favorite term) is handled differently in every state. Some states’ legislation define ACV (although sometimes that definition is limited to certain application—resulting in even further confusion).
For example, the Ohio legislature has promulgated Ohio Administrative Code Section 3901-1-54(I)(2), which states:
“If a fire and extended coverage insurance policy provides for the adjustment and settlement of losses on an actual cash value basis the following shall apply: (a) The insurer shall determine actual cash value by determining the replacement cost of property at the time of loss, including sales tax, less any depreciation…”[emphasis added by editor]
Simple enough, until the legislature went further to state in part (b):
“If the insured’s interest is limited because his property has nominal or no economic value, or a value disproportionate to the replacement cost less depreciation, the insurer is not required to comply with paragraph (I)(2)(a) of this rule regarding the determination of actual cash value.”
Well that’s helpful. Not!
Before we move on, what does “replacement cost minus depreciation” mean and how is it employed by insurers and insureds?
The common definition of “depreciation” is a helpful place to start.
Depreciation is defined as a “reduction in the value of an asset with the passage of time, due in particular to wear and tear.”
Fair enough.
But what factors are insurers entitled to depreciate from Replacement Cost (RC)? Clearly, material and material assets can be depreciated. How about non-material items like labor and general contractor overhead and profit? Can those non-material items be depreciated in attempting to arrive at the ACV of property?
The preceding is tough to answer since many jurisdictions have never addressed the issue. However, the general practice in the industry, is:
“[d]epreciation is limited to the effect of the passage of time in the decline in value of physical assets and is conceptually and practically inapplicable to labor.” See Adams v. Cameron Mut. Ins. Co., 430 S.W.3d 675 (Ark. 2013)
Thus, it seems that unless there has been a ruling in a jurisdiction to the contrary, the general practice should be that labor and other non-material items may not be depreciated. As the court further stated in Adams:
“Labor, on the other hand, is not logically depreciable. Does labor lose value due to wear and tear? Does labor lose value over time? What is the typical depreciable life of labor? Is there a statistical table that delineates how labor loses value over time? I think the logical answers are no, no, it is not depreciable, and no. The very idea of depreciating the value of labor is illogical.”
Still, it is an issue that is and will continue to be determined by the jurisdiction of the loss.
Finally, when material is “depreciated” for the reduction in its value for time, wear and tear, what standards exist or statistical tables define by what percentage a material item depreciates? Again, therein lies another issue with the adjustment and presentation of a property insurance claim by an insured. There are no universally accepted charts or tables. In practice, insurance companies use the famous “finger in the air” test, i.e. what can they get away with in terms of a depreciation percentage.
But, I have digressed. Let’s get back to attempting to define ACV.
Bottom line, the method of calculating the ACV of a claim has been left to each state when it is not otherwise defined in a policy. And the definition has evolved over time as courts have become more sophisticated.
Let’s look at Michigan, for example.The appellate courts of the State of Michigan used “Market Value” as the sole definition of ACV in the late 1800s. While this definition carried with it some reasoning regarding the valuation of real property: 1) it was/is unusual to insure real property for its market value (as it may have zero correlation to the cost to re-build), and 2) applying market value (MV) to determining the value of personal property made little sense, since much used personal property has almost no value on the secondary market. From there, in Michigan, the standard to determine ACV evolved to become the so-called “Broad Evidence Rule.” That rule meant/means that the insurers and policyholder could use any relevant factors, such as replacement cost, depreciation, market value, taxable value, income derived from the property, etc., to help establish the ACV.
Understandably, usage of the Broad Evidence Rule (BER) led to and leads to disagreements as to ACV, in practice, as there were and are no standards for weighing the various factors that make up ACV. Typically, the insurer wanted to weigh some factors more heavily depending on which side their benefit fell while the policyholder wanted to weigh other factors more heavily depending on which their benefit fell.
Although several states still employ the BER as the established standard for defining ACV, practically, it doesn’t result in settlement of the issue due the lack of standards in weighing factors. As long as we were discussing Michigan, the issue was finally settled in Michigan in 1992 when the Michigan Supreme Court in Smith v. Michigan Basic, stated “Actual cash value means replacement cost less depreciation.”
So far, our analysis herein has only discussed one state’s legislative work and another state’s judicial findings in any detail. In order to fairly treat this issue, we would need to offer an article detailing state by state, legislature by legislature, court by court treatment of the issue of definition of ACV. First, no one would read such an article. Second, state by state definition of ACV is constantly evolving as cases come to the judiciary.
At latest count, if I were to attempt to classify the definition of actual cash value into one category or another (understanding that this is a moving target as case law is made):
- 10 states use the property’s “fair market value” as the standard for defining ACV
- 12 states (including Illinois, Michigan, Pennsylvania and Wisconsin) use replacement cost minus depreciation as the standard for defining ACV
- 20 states (including Indiana and Minnesota) use the Broad Evidence Rule as the standard for defining ACV
- 1 state uses straight replacement cost as the standard for defining ACV
- 1 state uses mixed standards of the Broad Evidence Rule on total losses and straight replacement value on partial losses
- 6 states are undecided
Ideally, I have brought a tinge of clarity to this issue. Clearly, an insured can see that, while not re-building/repairing/replacing remains an option on any property (and that may be the option of choice for the insured depending on the circumstances), he/she first must understand:
- Whether ACV is defined in their policy;
- If not, determining what is the appropriate test for definition according to the jurisdiction of the loss;
- If it is replacement cost minus depreciation, determining whether labor and other non-material items be depreciated in that jurisdiction; and
- Notwithstanding,determining what can be depreciated, materials and/or labor, etc. and what is the appropriate percentage of depreciation under the circumstances.
And, if the test is something else, such as BER, what factors should be considered and how should they be weighed in attempting to come to a value for the ACV of a property?
Attempting to adjust a loss for “Actual Cash Value” is not for the inexperienced property owner. In order to come to a fair ACV, an insured needs to have a grasp on the legislative and judicial rulings in his/her jurisdiction as to the standard for ACV, whether labor can be depreciated and as to the generally accepted rate/table/chart of depreciation in a given jurisdiction for a given industry and for a given time period.
Ever tried that stunt on your own?
Alex N. Sill Company has successfully handled thousands of such assignments during our nearly 90 years of serving as a public insurance claims adjuster. We are expert at avoiding the shell game and finding the optimal solutions to maximizing the actual amounts recovered for the policy owner.
Contact a Sill public adjuster near you for assistance in such matters.