Trial lawyers are filing bad faith class action suits against insurance companies across the country in rapid fashion based on alleged wrongful depreciation of labor costs in their calculation of Actual Cash Value (ACV) in property loss claims. They smell blood in the water given the turmoil and lack of clear guidance from state to state regarding when or whether an insurer can withhold depreciation for labor in determining Actual Cash Value.
In a recently example, on February 8, 2023, Daniel and Betty Grawe filed a class action complaint against Trumbull Insurance Company—a subsidiary of The Hartford—in the U.S. District Court for the District of Connecticut. The lawsuit, filed on behalf of the Grawes and others similarly situated, alleges that Trumbull has been calculating replacement cost value (RCV) property claims inappropriately, and that “hundreds of thousands” of insureds in 15 states have been underpaid millions of dollars. The complaint alleges that Trumbull used Xactimate—an insurance claims estimating software—to calculate a deduction for the $1,000 deductible plus an additional amount of $1,504.70 holdback for depreciation, resulting in a net payment of only $8,802.81. In the handling of RCV claims, Xactimate allows for the depreciation of materials only, or the depreciation of both materials and labor.
This is only the beginning. Trial lawyers’ websites are filled with calls to action such as:
It is also very important to note, only physical items depreciate. Labor does not depreciate. If your insurance company is trying to depreciate anything other than the specific items, call us right away. They are in breach of their contract and likely acting in bad faith, and they cannot be allowed to continue this practice.
The purpose of a first-party property insurance policy is to put the insured back in the same financial condition the insured was in before a loss. It pays the insured an amount of money that will allow the insured to rebuild using materials of like kind and quality. But no insurance company can replace a 15 year-old roof with a 15 year-old roof. So, an ACV policy simply pays the insured an amount equal to the value of the damaged or destroyed property. If the insured wants to replace the roof, part of the cost of doing so will need to come out of the insured’s pocket.
There are two primary valuation methods for establishing the value of insured property for purposes of determining the amount the insurer will pay in the event of loss under the commercial property (CP), businessowners’ (BOP) or homeowners’ (HO) insurance policy:
- Replacement Cost Value (RCV): This method is usually defined in the policy as the cost to replace the damaged property with materials of like kind and quality, without any deduction for depreciation. It pays an insured for the value of replacing the damaged property without deduction for deterioration, obsolescence, or similar depreciation of the property’s value. The carrier assumes the cost of paying the full cost of repairing or replacing the damaged property.
- Actual Cash Value (ACV): This method pays an insured for a similar item less depreciation. ACV is ordinarily determined in one of three ways: (1) the cost to repair or replace the damaged property, minus depreciation; (2) the damaged property’s “fair market value” (“FMV”); or (3) using the “broad evidence rule,” which calls for considering all relevant evidence of the value of the damaged property. The insured bears the difference between the depreciated value of the damaged property prior to loss and the higher cost of repairing or replacing it.
If the policy in question defines actual cash value, or even depreciation, the theories above might not apply. The carrier applies depreciation and calculates actual cash value as defined in the policy. Actual cash value is traditionally defined within insurance as “replacement cost less physical depreciation.” However, none of today’s “standard” property forms promulgated by the Insurance Services Office (ISO) actually define “actual cash value.” In fact, use of the term “depreciation” in direct relation to the application of ACV has been missing since the release of the 1943 NY Standard Fire Policy. Prior to 1943, the property form specifically stated unequivocally that ACV was arrived at via reasonable depreciation. Today, ISO-based forms only indirectly suggest that the concept of actual cash value employs depreciation. On the other hand, Replacement Cost policies (RCV) policies pay the insured what it would cost to replace the damaged property with new items, and do not take depreciation into consideration.
The reason ACV is rarely defined is that it is incredibly difficult to do so. There is a multitude of types of depreciation, including:
- Physical depreciation: (normal wear and tear that assets experience over time. Something equivalent to a property’s “useful life”);
- Economic depreciation (measure of the decrease in the market value of an asset over time from influential economic factors);
- Obsolescent depreciation (loss in value that is related to asset quality. Higher quality represents a barrier to depreciation and obsolescence);
- Functional depreciation (loss in value that is caused by defects in the design of a structure or by changes in market preferences that result in some aspect of a property being considered obsolete by current standards); and
- Accounting depreciation; and accounting depreciation; insurance focuses on physical depreciation. Physical depreciation is somewhat equivalent to “wear and tear” or a property’s “useful life.”
States are slow to provide insurers with the guidance they need, and many states still have not decided this issue. In a recent Arizona Supreme Court ruling, the court decided an issue which was both a matter of first impression in that state, as well as a contested legal issue shining a light on a growing issue in a number of other states. In Walker v. Auto-Owners Ins. Co., 517 P.3d 617 (Ariz. 2022), Gerald and Ada Walker sustained water damage to their home due to a failed appliance and an insurance claim was made with their homeowner’s carrier, Auto-Owners Insurance Company. Their insurance policy contained a section entitled “Property Protection”, describing “How Losses Are Settled.” However, the policy did not define the terms “actual cash value” or “depreciation.” Although Auto-Owners endorses some of its homeowners’ insurance policies with Form 57911, it did not do so with the Walkers’ Policy. Form 57911 defines “actual cash value” and “depreciation” as follows:
- “Actual cash value” means the cost to repair or replace lost or damaged covered property with new property of similar quality and features reduced by the amount of depreciation applicable to the lost or damaged covered property immediately prior to the loss.
- “Depreciation” means a decrease in value because of age, wear, obsolescence or market value and includes … the cost of materials, labor and services … necessary to repair or replace lost or damaged covered property.
The Walkers’ policy contained replacement cost coverage (also known as “replacement cost value” or “RCV”), but also provided an ACV option, which is the provision that applied to the Walkers’ loss. It read:
If you do not repair or replace the damaged covered property, we shall pay the actual cash value of the property at the time of loss. Actual cash value includes a deduction for depreciation.
Auto-Owners depreciated both materials and labor when calculating the ACV of the Walkers’ loss. The insured filed a class action suit against Auto-Owners in federal court, alleging breach of contract and asking for declaratory and injunctive relief. The Walkers alleged Auto-Owners underpaid them and other similarly situated insureds by depreciating both materials and labor when calculating property damage claims under their homeowners’ insurance policies. The federal judge certified the following novel questions of law to the Arizona Supreme Court:
- What does Actual Cash Value mean; and
- Can or should labor be depreciated when developing the ACV?
The answer to both questions in any given claim depends on the state in which the property is located, and whether ACV is defined in the policy.
As to the first question, the Supreme Court held, as a matter of first impression in Arizona, that where an insurance policy does not define “Actual Cash Value” or the methodology to be used for determining it, Arizona insurers must use the following approach:
- Where market value is easily determined, ACV is market value.
- If there is no market value, replacement or reproduction cost may be used.
- Failing the other two tests, any evidence tending to formulate a correct estimate of value may be used, which is known as the “broad evidence rule.” The broad evidence rule provides that actual cash value may be determined by considering every fact and circumstance which would logically tend to the formation of a correct estimate of the property’s value, including the original cost, the economic value of the property, the income derived from the property’s use, the age and condition of the property, its obsolescence, both structural and functional, its market value, and the depreciation and deterioration to which it has been subjected.
The court held that the broad evidence rule did not apply because the Walker’s policy defined actual cash value as replacement cost less depreciation.
As to the second question, the court held that under the terms of the Walker’s policy, Auto-Owners could not depreciate the cost of labor when determining the ACV. When discussing the depreciation of labor, the court is referring to future labor—for example, the cost of labor to remove and replace a floor installed in 2010 that was damaged in 2022. They are not referring to the labor performed in 2010, which was included in the value of the floor before the loss. It is undisputed that the proper valuation of the property pre-loss includes depreciation of both labor and materials because those two components cannot be separated once the floor has been constructed.
An explanation of the difference between policies that permit depreciation of both materials and property and a policy that permits depreciation of materials only is found in Mitchell v. State Farm Fire & Casualty Co., 954 F.3d 700 (5th Cir. 2020):
[The insured’s] interpretation of “Actual Cash Value” includes depreciation of only the material components of the roof. Suppose the hypothetical roof can be replaced for a cost of $5,000 in materials and $5,000 in labor—a $10,000 roof. Suppose that the destroyed roof was 10 years old and expected to last 20 years. Under [the insured’s] interpretation, the Actual Cash Value would be $7,500, because $2,500 would be deducted in depreciation (half of the cost of the materials).
By contrast, [the insurer’s] interpretation of “Actual Cash Value” includes depreciation of both the materials and the labor in constructing the roof. Using the same example, [the insurer’s] interpretation would yield an Actual Cash Value of $5,000, because $5,000 would be deducted in depreciation (half of the total cost of replacing the roof).
The Supreme Court held that Arizona would join the growing number of states which have determined that labor may not be depreciated. This issue divides the states and even divides states from federal courts. The relevant language in the Walkers’ policy states:
If you do not repair or replace the damaged covered property, we shall pay the actual cash value of the property at the time of loss. Actual cash value includes a deduction for depreciation.
Citing case law from Illinois and Arkansas, the Supreme Court held that, in Arizona, depreciation may not be applied to the intangible labor component. When a policy adopts the Replacement Cost Less Depreciation methodology for determining Actual Cash Value (as the Walker’s policy did), the carrier is precluded from depreciating labor when determining the actual cash value of the covered loss.
A chart depicting the law in all 50 states with regard to whether or not a property insurer is allowed to depreciation labor in a policy which adopts the Replacement Cost Less Depreciation methodology for determining the actual cash value of property, can be found HERE. While the depreciation of labor and its role in determining ACV is not directly related to subrogating insurance claims, explaining claim payments surely is; and understanding this nuanced issue within the insurance industry is simply another weapon in the arsenal of any good subrogation firm.
For questions relating to aggressive insurance subrogation in all 50 states, please contact Lee Wickert at leewickert@mwl-law.com.
Lee R. Wickert is a senior associate attorney in our Austin, Texas branch office. Lee was located in in our Wisconsin office, but transferred to our Austin, Texas branch office when it was opened in May 2019. Lee’s practice focuses on insurance litigation, subrogation, workers’ compensation, health insurance and ERISA, automobile insurance, property and casualty, and insurance coverage. Lee is a graduate of the University of Wisconsin-Milwaukee and obtained his law degree at Marquette Law School and his M.B.A. at Marquette University. Lee is licensed to practice in Texas and Wisconsin.
