Don’t Deduct Depreciation When Calculating Actual Cash Value (ACV) for a Partial Loss?

Does Actual Cash Value equal replacement cost less depreciation? Don’t be so sure. A recent NY court case held that the insurer could not deduct depreciation when calculating the actual cash value of a partial loss1. The valuation provision in the policy read as follows:

9. Valuation

We will determine the value of Covered Property in the event of loss or damage as follows: a. At actual cash value as of the time of loss or damage… There are exceptions, but they didn’t apply to this loss.

The court said that, unlike older New York policies, the policy in question did not specify that recovery based on actual cash value is ascertained with proper deductions for depreciation. The reference to a proper deduction for depreciation was eliminated in the 1943 revision of the New York Standard Fire Insurance Policy—it had appeared in the prior 1918 version. Because those words are no longer used, the judge ruled that depreciation could not be deducted in calculating actual cash value. Most current forms don’t include the depreciation wording, but even if they did, insureds could argue against its application to fire losses. As I pointed out in an article in the April 19th, 2010 edition of the Insurance Advocate, insurance laws in New York and many other states provide that the insured is entitled to any advantages provided by the 1943 Standard Fire Policy wording no matter what a current policy says.

Is ACV still important?

We sometimes think that almost all policies are written on a replacement cost basis, but that’s not correct. Right off the bat you have all the New York Property policies—approximately 60,000. Furthermore, replacement cost coverage is only an option in the ISO commercial property forms used by most insurers. Lots of insureds don’t elect replacement cost coverage because they don’t want to spend the additional premium2, the insurance company won’t provide the coverage, or they weren’t informed that the option was available. Homeowners policies provide replacement cost, but only if the amount of insurance equals 80 percent of the replacement cost. If it doesn’t, recovery is the higher of the ACV of the loss or a coinsured payment based on the amount carried divided by 80% of the replacement cost times the amount of the loss. Many BOP policies provide replacement cost coverage as the standard, but ISO BOP policies follow the homeowners model. The result: lots and lots of losses are settled on an ACV basis.

What is the definition of ACV?

In Insurance 101 we learned that “ACV equals replacement cost less depreciation” is written in stone. This decision seems to be an aberration that violates the rule. However, New York courts have decided against a deduction for depreciation in a number of previous cases. The leading one, Lazaroff v Northwestern National, was decided in 1952 and affirmed on appeal.3 The New York Court of Appeals (New York’s highest court) dealt with the meaning of ACV in McAnarney v Newark Fire Insurance Company (247 NY 176 159 N.E. 02 1928). McAnarney posed an interesting problem for the court. In 1919 McAnarney purchased seven buildings designed for use as a brewery for $8,000 and in January 1920 insured them with various insurance companies for a total of $60,0004 $60,000 was probably a reasonable valuation based on replacement cost less depreciation. The buildings were destroyed by fire in April 1920.

McAnarney submitted a claim for $60,000 based on replacement cost less depreciation. However, the 18th amendment, which prohibited the manufacture, sale, or transportation of intoxicating liquors in the United States, had been ratified on January 16, 1919. Because that greatly affected the value of the buildings, the insurance companies disputed the claim. They pointed out that McAnarney had been unable to find a purchaser for the buildings even though he advertised them for sale for $12,000; that he had submitted an affidavit to the local assessors saying that the buildings had no value as they were only suitable for the manufacture of malt liquor, which was illegal under Prohibition; and that the best offer he had received for the property was $6,000.5 In the court case that followed, the jury awarded McAnarney $55,000. The insurers appealed and the Court of Appeals reversed the lower courts. It wrote: Indemnity is the basis and foundation of all insurance law. The contract with the Insurer is not that, if the property is burned, he will pay its market value, but that he will indemnify the assured, that is, save him harmless or put him in as good a condition, so far as practicable, as he would have been in if no fire had occurred.

In effect, the court rejected both the insured’s claim that actual cash value equals replacement cost less depreciation and the insurer position that it equaled market value. As a standard for determining the payment that would restore the insured to the same condition that existed before the loss, the Court adopted what’s come to be known as the broad evidence rule. The broad evidence rule says that everything that bears on the value of property should be considered. The list of possible factors is a long one. Here are some of them:

• market value
• replacement cost
• depreciation
• original cost
• condition of the property
• location
• use
• assessed value
• offers to sell
• offers to purchase6

The court in Goorland v New York Property discussed McAnarney pointing out that it is the “seminal case” on the subject. The strength of the broad evidence rule is its inclusiveness. The problem is that it doesn’t provide a specific method for doing the calculation. Which factors do you consider? How much weight do you give to each of the factors?

What’s happening in practice?

Insurance companies did raise the broad evidence issue in the 1970s when arson was ravaging wide areas of New York City and real estate values had fallen through the floor. The market value of many buildings was far lower than replacement cost less depreciation. Insurance companies wanted that factored into the settlement of large losses. It was not unusual to have a building that was insured for $1,000,000 sustain a loss, on an ACV equals replacement-cost-less-depreciation basis, that equaled or exceeded the amount of insurance. At the bottom of the market, buildings in depressed areas were selling for one-times annual rents7. The market value of such a building might have been $200,000 or less; many insurance companies argued that the broad evidence rule indicated that ACV for such a building was close to $200,000. In certain situations, insureds also seized on the market valuation approach as a way to reduce or avoid coinsurance penalties for smaller losses. However, even then the typical ACV loss was adjusted on the basis that ACV equals replacement cost less depreciation and that continues to be the case today. Will we see a change in this standard? My guess is that, despite the court decisions, replacement cost less depreciation will continue to be the way insurers want to settle losses. Insureds will have to resort to the courts to recover more than replacement cost less depreciation for ACV losses.

The situation in other states

The broad evidence rule is widely accepted, although some states (for example California) specify that ACV equals market value. I’ve focused on New York decisions in this article, but here’s what a Google search turned up for our surrounding states: New Jersey: Ward v. Merrimack Mutual Fire Insurance Co. Superior Court Of New Jersey Appellate Division A-5831- 98T5 (1998) stated: “New Jersey employs the ‘broad evidence rule’ under which the appraiser must consider ‘every fact and circumstance which would logically tend to the formation of a correct estimate of the loss,’ so as to effectuate complete indemnity.” The court cited a 1978 New Jersey case and noted that it quoted the McAnarney decision.

Connecticut: Sullivan v. Liberty Mutual Insurance Company 174 Conn. 229, 384 A.2d 384 (1978). The Connecticut Supreme Court wrote that the broad evidence rule allows consideration of any evidence “logically tending to establish a correct estimate.”Pennsylvania: I wasn’t successful on the Internet for PA, but this is from Munich Re’s First Party Property Claims Desk Reference: “Pennsylvania… Replacement cost less depreciation, but only where the policy so defines ACV and ultimately provides replacement cost coverage Kane v. State Farm, et. al. 841 A.2d 20 1038 (P.A. Super 2003). Otherwise, ACV means replacement cost without deduction for depreciation. Fedas v Insurance Co., 151 A. 285 (1930)”

If I were King

If I could make the rules, I would focus on betterment. That is, is the insured in a better position after the loss is paid than it was before the loss? If so, a deduction is in order. If not, then replacement cost should be the standard. For example, if a fire destroys one apartment in a multifamily dwelling replacement of structural elements will probably not produce any economic benefit for the insured. Repainting the apartment if it hasn’t been painted in several years, probably would. My position is that the component items in a loss should be looked at separately. For some, a deduction for betterment is proper; for others it’s not.

For property that isn’t going to be repaired, I’d go for a market-value standard: would the lack of the repairs reduce the market value of the property? If so, that’s the measure of the loss. If not, the insured hasn’t sustained any loss until the repairs are done.

What do you think?