Author: VU Faculty

After a fire damaged an insured's home, the HO adjuster offered to pay only part of the repair bill, stating that he was taking depreciation off the total. The agent was surprised since this was a current ISO HO-3 policy with replacement cost coverage on the building. Although the carrier can pay ACV until actual repair or replacement takes place, can the actual repair costs be depreciated?

"My client bought a homeowners policy. After a fire that damaged the home, the insurance company offered to pay only part of the repair bill stating that they could take depreciation on a repair bill. Since this is a replacement cost policy, I was surprised. I thought the settlement would be replacement or repair, and replacement was required or they could pay ACV. I understood ACV is replacement cost minus depreciation. I thought ACV could be paid on a total if the insured did not replace. Please advise me of your thoughts. Thank you."

Without knowing exactly what was damaged, whether this is an ISO HO-3, and knowing the adjuster's logic, all we can do is surmise as to what premise the adjuster is relying upon to depreciate repair costs on a replacement cost policy. As you can see from the faculty comments below, it's hard to rationalize what the claims rep could be thinking.

Note to Readers: When using our "Ask an Expert" service, PLEASE include the policy form number and edition date such as HO 00 03 10 00. Without knowing the specific contract language, our responses may be little more than guesswork. If the contract is a non-ISO policy, the ENTIRE form can be faxed to us at the efax number provided on the "Ask an Expert" form.

Does the policy contain a subsection permitting ACV payment on certain components? Could these be the things being depreciated? Old boiler type heating systems are occasionally exempted from RC policy terms. If there isn't an exemption in the contract language, specifically one that permits depreciation on repair costs, the carrier is mistaken.

I belive they are most likely wrong. I wrote an article that might help you. It can be found at http://www.zalma.com/depreciation.pdf

There should be no depreciation taken if the loss settlement basis is replacement cost. If settlement is on an ACV basis, many courts have ruled that depreciation of repairs in a partial loss is not permitted. Consult state-specific legal sources.

No, depreciation cannot normally be deducted from the cost to repair property insured on a replacement cost basis. The policy says it won’t pay more than actual cash value (depreciated value) until the property is repaired or replaced, but a repair bill would indicate the property was repaired. If repair or replacement involves using better than like kind or quality materials, then in some cases a deduction for betterment may be appropriate. But that’s not depreciation. It’s not a deduction taken for the property being newer or having it’s life extended...that kind of betterment is included in replacement cost coverage.

Here is what the current ISO HO-3 form says (assuming this is the language in the subject policy):

If, at the time of loss, the amount of insurance in this policy on the damaged building is 80% or more of the full replacement cost of the building immediately before the loss, we will pay the cost to repair or replace, after application of any deductible and without deduction for depreciation, but not more than the least of the following amounts:

(1)  The limit of liability under this policy that applies to the building;

(2)  The replacement cost of that part of the building damaged with material of like kind and quality and for like use; or

(3)  The necessary amount actually spent to repair or replace the damaged building.

What is so difficult to understand about "we will pay the cost to repair or replace...WITHOUT DEDUCTION FOR DEPRECIATION"??? The loss settlement provision goes on to say that the insurer will pay the lesser of the limit, replacement cost, or "amount actually spent to repair" the damage building. It doesn't say it'll pay the "amount actually spent to repair LESS A DEDUCTION FOR DEPRECIATION."

Unless the carrier's policy is dramatically different from this, you do NOT depreciate repair costs on either a replacement cost or ACV policy. Even for the property in the policy covered on an ACV basis, the policy says it pays, "at actual cash value at the time of loss but not more than the amount required to repair or replace." Again, nowhere does it give the insurer the authority to depreciate repair costs even under ACV coverage.

I'd suggest the adjuster take a few minutes and read his or her own policy. If it's equivalent to the ISO forms, you do not deduct depreciation from repair costs. The policies typically pay the lesser of replacement cost or repair cost. There's no deduction for depreciation at all for most building damage under a replacement cost HO policy. In fact, there's no deduction of depreciation on repairs under an ACV policy. Numerous courts have ruled on this, including the Nebraska Supreme Court (which cites several other courts):

Supreme Court Rules Repair Costs Not Depreciable

The Supreme Court of Nebraska has ruled on a dispute involving actual cash value, and this ruling has prompted a reaction on the part of the Nebraska Department of Insurance. The case is Olson v. Le Mars Mutual Insurance Company of Iowa, 696 N.W.2d 453 (Neb. 2005).

There was no dispute over the facts in this case. Olson owned a grain storage building that was insured under a policy written by Le Mars; the building was approximately forty years old. The building was partially damaged by hail and the cost of repair was set at $95,040. Olson had a $500 deductible and had not purchased the optional replacement cost coverage. Olson demanded the amount of his loss, minus the deductible, but the insurer deducted $36,710.40 for depreciation and offered Olson the sum of $57,365.60. Olson refused that amount and he filed a lawsuit against Le Mars. The lower court found in favor of Olson and the appeal went to the state Supreme Court.

The Supreme Court noted that the dispute involved whether Le Mars was obligated under its policy to pay the amount Olson claimed was due, or whether the insurer was permitted to deduct a depreciation factor from the repair cost in order to arrive at a net amount due. The court also noted that the policy in question here did not include a specific definition of actual cash value. In such circumstances, the court said, there was a priority of rules to determine actual cash value. The rules are:

where market value is easily determined, actual cash value is market value;

if there is no market value, replacement or reproduction cost may be used;

failing these two tests, any evidence tending to formulate a correct estimate of value may be used.

(In two previous cases, the Nebraska Supreme Court had held that actual cash value was the market value, which is the amount for which property may be sold by a willing seller who is not compelled to sell it to a buyer who is willing but not compelled to buy it. The court further stated that, in determining such value, the finder of fact should consider the situation and the condition of the property as it was at the time of loss, and all other facts and circumstances shown by the evidence that affected or had a tendency to establish its value.)

The insurer contended that, because it insured the building for actual cash value (at Olson's choosing), the deduction of depreciation was proper. Le Mars also urged the court to adopt the broad evidence rule which permits a finder of fact to consider every fact and circumstance that would logically tend to the formation of a correct estimate of the building's value. Such facts and circumstances would include the original cost of the building, the economic value of the building, the income derived from the use of the building, the age, condition, and market value of the building, and the deterioration to which the building had been subjected over the years.

The Supreme Court indicated that it had no particular quarrel with that definition, but stated that actual cash value must still be measured as an economic unit, or fair market value. The court also looked to other jurisdictions for guidance on whether depreciation should be deducted from repair costs under actual cash value coverage; the court cited cases from Kansas, South Dakota, Pennsylvania, Florida, Montana, Indiana, and New Jersey. The court found that most of the cases addressing the issue focused on the principle that an insured under an actual cash value policy is entitled to be indemnified for the actual amount of property loss, but should not be permitted to benefit from the loss. And, using this guidance, the court found that Le Mars was not permitted to depreciate its payment to Olson.

The court said that there was undisputed evidence in this case that the value of the building as an economic unit was $200,000 immediately prior to the hail damage. The repair costs would not cause the actual cash value to exceed this amount. Therefore, recovery of the full repair costs without a depreciation deduction would simply restore the value of the insured property that existed immediately prior to the loss, but would not enhance that value. Accordingly, the court concluded that under an actual cash value policy that does not expressly provide otherwise, an insurer could not deduct depreciation from the cost of repairing partial damage to insured property where the actual cash value of the property, as repaired, did not exceed its actual cash value at the time of the loss.

This ruling by the Nebraska Supreme Court prompted the state Department of Insurance to notify insurers that deduction for depreciation will not be permitted under Nebraska law.

Your Personal Lines article in this month's newsletter is a bit confusing to me, Bill, and I fear your faculty may have missed the obvious.
 
In HO settlements it is very common for insurers to deduct depreciation in the initial settlement. This is commonly called a "hold-back" and is authorized by the Loss Settlement provision, Condition C of the HO 00 03 10 00, for example.

If you look at Condition C.2.d., it allows the insurer to hold back depreciation (difference between RC and ACV ) until repairs are completed. This provision is not applicable if the loss is "both (1) Less than 5% of the amount of insurance in this policy on the building; and (2) Less than $2,500."
 
So for the smaller claims the adjuster pays the full replacement cost and closes his file. But on more serious claims, he makes the insured "whole" by paying ACV, until repairs are done and then he pays a supplemental payment up to the actual cost of repair or replacement. The insured has 180 days from the loss date to claim the "hold-back" by doing the repairs and sending the insurer the repair bills (C.2.e.).
 
We have had this come up often with hail damage to a roof. Generally a roof will cost more than $2,500 to replace, so the adjusters give the customer enough money (ACV) to order the materials and engage a roofer to replace the shingles. When done, the final bills are sent to the insurer to claim an amount between actual costs, and the amount initially paid. 

Our biggest problem with this provision is that 180 days is not generally enough. In the Northern climate of Montana, damage from a hailstorm that occurs between July and October generally cannot be replaced before the next season, and often takes a year or more to get the work done. Insurers have generally been agreeable to extending the 180 day requirement of C.2.e. But we would like to see that extended, by ISO change, to 365 days.
 
In your Newsletter item, I suspect the fire loss was severe enough that the insurer was applying the provisions I cite above, but no one on your faculty referenced it.
 
Tom Clarke
Clarke Insurance, Inc.
Miles City, Montana

Tom, thanks for the feedback. It's always welcome.
 
Regarding the article, perhaps it wasn't clear and I can add our exchanges it to make it so. This was the final settlement after repairs had been completed, not an initial offer pending repair. The adjuster is wrong, under the contract language and case law we're familiar with, that you can deduct depreciation from repair costs, even under an ACV policy, much less a RC policy.
 
The policy provision you cite was mentioned by the questioner and acknowledged by one of the faculty responses above:

"I thought the settlement would be replacement or repair, and replacement was required or they could pay ACV. I understood ACV is replacement cost minus depreciation. I thought ACV could be paid on a total if the insured did not replace."
 
"No, depreciation cannot normally be deducted from the cost to repair property insured on a replacement cost basis. The policy says it won’t pay more than actual cash value (depreciated value) until the property is repaired or replaced, but a repair bill would indicate the property was repaired."

I was actually trying to avoid a discussion of the policy provision you mention since the focus was on whether or not depreciation can be deducted from repair costs as opposed to pay the lesser of depreciated value or repair costs. I can expound on the issue you raise or just add your comments if you think it might result in avoiding potential confusion.

It's an important point. There's another VU article about a water leak that caused $14,000 in damage to hardwood floors and the adjuster cut a check for that amount. The insured spent one-tenth of that on sanding and buffing the floors and pocketed the rest. The article focused on an ethical dilemma of the insured but, from a practical standpoint, the adjuster was foolish for cutting a check without insuring that actual replacement was effected.

Also, with regard to the 180-day provision you mentioned, there is still another VU article you might find helpful. If we're talking about the ISO HO-3, the policy doesn't actually require replacement within 180-days...it only requires that the insured advise of his or her intent to do so within 180 days. ISO even amended the wording in the 2000 policy to make it clear. The reasoning is exactly because of the problem you state where repairs may be delayed for months and months due to weather or other conditions (such as scarcity of labor and materials following a major catastrophe like a hurricane).

Good points, Bill. I had noticed the reference to the provisions in C.2.d. in the question, but did not see a reference to this in any of the responses. I do think it could have been made clear that this was a final settlement applying ACV provisions if you amend the article.
 
C.2.d is obviously in the policy to prevent unjust enrichment, as in the water damage case you referenced. Quite often a homeowner in our area would take the ACV settlement on his hail damaged roof, not replace the shingles, then move to another insurer and wait until another storm came along and get paid again.  With CLUE systems that doesn't work as well today as it did before. 
 
To emphasize your point about replacement cost coverage, we had an insured buy a home with a hail damaged roof. It wasn't visible on our inspection when we first wrote it, but a year or so later when another storm came through the adjuster identified the prior damage, and tried to not pay anything. Then he tried to pay ACV, but when the Insurance Commissioner put their feet to the fire (made them comply with the policy), they paid for a new roof.

Tom

Update

In the “Court Decisions” column of the April 2014 edition of Rough Notes magazine (p. 6, "Can Insurer Depreciate Labor in ACV Policy?”), the case of Adams v. Cameron Mutual Insurance Company, November 2013 is discussed. Following a tornado loss to a home insured on an ACV basis under an HO policy, the insurer depreciated both labor and materials. The Arkansas Supreme Court ruled that labor is not depreciable in determining ACV since it does not lose value over time or because of wear and tear.

Last Updated:  April 13, 2014