Calculation of Actual Cash Value When Defined as Replacement Cost Less Depreciation – Claims Magazine

QUESTIONS:

What are the components of actual cash value when defined as replacement cost less depreciation? Which of these components may be depreciated?

CONCLUSION:

All construction elements, including materials, supplies, labor, fees, permits, and sales tax should arguably be included in replacement cost to the extent that they are part of the theoretical cost of replacement at a given site for like kind and quality. They should then be depreciated in order to amortize their cost over the life span of the property.

Only the element of debris removal has been treated differently. This is because debris removal is an additional coverage in the policy, rather than being covered as part of the direct physical loss.

DISCUSSION:

Introduction

Standard policies do not define the term actual cash value. Courts have used three definitions: (1) replacement cost less depreciation, the traditional method; (2) market value; and (3) the broad evidence rule. The questions posed here only arise if a court defines actual cash value as replacement cost less depreciation. (When calculating market value, the various individual components, such as supplies, materials, labor, overhead, profit, are not directly related to the calculation. The broad evidence rule considers both replacement cost less depreciation and market value, and any other evidence relevant to determining value. Therefore, consideration of specific components is not at issue if actual cash value is defined as market value or according to the broad evidence rule.)

When actual cash value is defined as replacement cost less depreciation, replacement cost must be ascertained. For purposes of this equation, the calculation of replacement cost is based on what it would cost to replace, or repair, the item in question; it is not based on actual repair costs. Until the insured actually replaces, all components of replacement cost are theoretical, because none are actually integrated into the item being replaced. (This theoretical measure of replacement cost is like one of the limits on replacement cost set forth in standard policies: "the replacement cost of that part of the building damaged for like construction and use on the same premises." This theoretical measure serves as a cap on the insured's recovery in the event that the cost of actually rebuilding or repairing costs more than what it would have cost to rebuild on the same site.)

Calculating Replacement Cost: The First Part of the Equation

There is no question that material, supplies, and labor should be included in any calculation of replacement cost for purposes of calculating actual cash value. But should overhead and profit be included? Courts have held that, assuming a general contractor would be needed for the work in question, an allowance for a general contractor's overhead and profit must be included. See, for example, Gilderman v. State Farm Ins. Co., 649 A.2d 941 (Pa. Super. 1994); Salesin v. State Farm Fire & Cas. Co., 1998 WL 193518 (Mich. App. 1998); and Mazzocki v. State Farm Fire & Cas. Corp., 2003 WL 22455742 (N.Y. App. 2003).

Two primary concerns have dominated the debate over whether to include contractor's overhead and profit as part of replacement cost for purposes of calculating actual cash value. First, claims people argued that if an insured is not paying for a general contractor's overhead and profit, given that the insured is not repairing or replacing, these elements should not be included. As discussed above, none of the elements of repair or replacement, not even supplies, materials or labor, are actually purchased unless the insured repairs or replaces. Thus, the fact that overhead and profit are not actually expended does not distinguish them from supplies, materials, and labor. Therefore, not surprisingly, this reason for omitting overhead and profit from a replacement cost calculation has been rejected in the cases cited above.

The second objection to including a general contractor's overhead and profit as part of replacement cost for purposes of calculating actual cash value was that a general contractor is not needed for every job. Whether a general is needed depends on the size and nature of the job. In the cases cited above, the courts have been receptive to this argument. They have stressed that a general contractor's overhead and profit is to be included only if a general contractor would be required for repair or replacement of the property in question.

Overhead and profit may sometimes be included in a replacement cost calculation even if a general contractor is not required for the job. The overhead and profit in those instances would be for individual contractors. However, many trades' people have their overhead and profit built into their price. Whether overhead and profit is built into a price must be determined in order to ascertain whether to add an additional percentage for overhead and profit.

Taking Depreciation: The Second Part of the Equation

Of these elements, labor, overhead, and profit, which may be depreciated? All three may be depreciated. Litigation in this area has concerned the element of labor. See Redcorn v. State Farm Fire & Cas. Co., 2002 WL 386079 (Okla. 2002), and Branch v. Farmers Ins. Co., 2002 WL 378169 (Okla. 2002).

Depreciation represents the amortization of the value of property over the "life span" of the property. A new antenna mounted on an insured's roof is worth more than a new antenna in its shipping container lying on the insured's lawn. This is because the installation of an antenna usually results in the labor charge for a skilled technician. Thus, the replacement cost of an antenna properly roof mounted includes both the cost of the antenna and the cost of the installation. If this antenna were damaged by windstorm immediately after installation, the replacement cost of the antenna for which the company would be liable would include both the replacement cost of the antenna and the full cost of the installation. If the average "life expectancy" of an antenna is ten years, the cost of both materials and labor should be amortized over this ten-year period.

Or, as the majority in Redcorn put it:

[The policyholder] insured a roof surface, not two components, material and labor. He did not pay for a hybrid policy of actual cash value for roofing materials and replacement costs for labor. To construe the policy in such a manner would unjustly enrich the policy holder.

In fact, it seems reasonable for all of the construction elements, including fees, permits, and sales tax, to be treated similarly to overhead, profit, and labor. To the extent that they are part of the theoretical cost of replacement at a given site for like kind and quality, they should be included in that replacement cost and then depreciated for purposes of calculating the actual cash value of the loss.

Debris Removal: An Additional Coverage

Only the element of debris removal has been treated differently. This is because debris removal is an additional coverage in the policy, rather than being covered as part of the direct physical loss. Because it is an additional coverage, it need not be included in the theoretical replacement cost. Further, because the additional coverage does not mention depreciation, debris removal cannot be depreciated. One court has held that, although the labor involved in putting on a new roof may be depreciated, the cost to tear off old roofing materials may not be. See Branch v. Farmers Ins. Co., 2002 WL 378169 (Okla. 2002). See also, Davis v. Mid-Century Ins. Co., 2002 WL 3157952 (10th Cir. Okla. 2002), where the federal appellate court adopted the opinion of the court in Branch.