ACTUAL CASH VALUE: No Easy Answer

Our October newsletter was titled “Functional Replacement Cost or Actual Cash Value” and promised to discuss, in a future publication, the various methods for determining the actual cash value of a loss. The future is now.

As we previously offered, actual cash value is a measure of damage that is akin to the reasonable “fair market value” of the destroyed or damaged property. It is euphemistically referred to as “old for old.”

Although most insurance policies were historically written on an actual cash value basis, the modern policy is one carrying replacement cost as the promise of indemnity.

So, isn’t a discussion of actual cash value merely of academic interest-- and perhaps only to insurance historians?

Not really.

Although replacement cost is in current vogue: some carriers only offer actual cash value coverage; some carriers offer replacement cost only as an optional coverage and at an additional premium; some insureds opt for the lesser indemnity to save premium dollars.

And, most importantly, actual cash value is the basis for the payment(s) made to the insured until actual replacement or repair of the property has taken place.

Of the several methods for determining the actual cash value of a loss, four predominate. They are:

Fair Market Value
Broad Evidence Rule
Replacement Less Depreciation (or, no depreciation)
California Rule

Fair Market Value

An accepted definition of “fair market value” is the price at which a willing buyer and a willing seller--both having reasonable knowledge of relevant facts and neither being under duress, economic compulsion, or other limiting circumstances-- would agree to the transaction in an open and unrestricted marketplace.

On its face, the test seems simple enough: what will the market bear? This may be easy to apply for real property losses but, sometimes, not so for personalty.

Usually, real property involves land and buildings which have an established market-- determined by comparable sales, reproduction costs, or income capitalization-- so actual cash value or fair market value is conceptually easier to calculate. But even here, there are certain nuances and exceptions; including special purpose property having no established market such as churches, schools, recreation facilities, cemeteries, utilities, and others of like ilk.

In such situations, replacement cost (with or without a deduction for depreciation) or “best evidence” may be the alternative and appropriate measure of loss.

Unlike realty, the loss of personal property often causes more issues and difficulties of determination. There may be no market (used clothing). The item may be unique and one of a kind (works of art), experimental products (R&D), custom machinery, etc. Here, the general rule is that value may be determined by “any method of valuation that is just and equitable.”

Broad Evidence Rule

The Broad Evidence Rule (aka “The New York Rule”) has been adopted by numerous states and provides that anything and everything that bears on the value of property should be taken into consideration. Under this approach, the list of factors one may consider is almost endless and may include:

market value
replacement cost
repair cost
reproduction cost
original cost
condition of the property
location of the property
use of the property
assessed value
appraisals
prior offers to purchase or sell
expert opinions
owner’s opinion

Replacement Less Depreciation

Many states and most carrier adjusters-- staff and independent-- approach the valuation issue by use of replacement with a deduction for depreciation.

To understand this method of valuation, a few general definitions are in order:

replacement cost: the cost to replace the lost item with an identical or similar one used for the same purpose; the cost to replace the lost item with one of like kind and quality
depreciation: the gradual decrease in the value of the property over time reflecting factors such as wear and tear (physical) and obsolescence (economic and functional)
physical: factors such as age, condition, maintenance and care, and remaining useful life are all relevant in deciding on how much of a deduction should be taken from replacement cost
functional obsolescence: a reduced desirability or usefulness of a property because of outdated features, design, technology, or other similar factors-- all of which bear on the issue of value. Factors may include small bedrooms when large are now wanted, linoleum floors when tile or hardwood is the “in” thing, flocked wallpaper, shag carpet, etc.
economic obsolescence: the decrease in the value of a property resulting from external changes in the economy or neighborhood. Factors include such events as increase in mortgage rates, changes in zoning and use permits, increase in crime levels, closing of “good” schools, loss of neighborhood markets, restaurants, movie theatres and other amenities, etc.

The use of the replacement less depreciation method for calculating the actual cash value of a loss is not always easy.

Some insurers and their representatives use a relatively simplistic approach by treating depreciation as strictly an age issue.

In this case, after deciding or agreeing upon an item’s replacement cost, reference is made to established tables setting forth that item’s useful life, then a determination of the useful years remaining and finally a calculation of the appropriate depreciation percentage.

For example, assume the replacement cost of the property is $50,000 and reference to a table has the useful life to be 20 years. At the time of the loss, the item had been in use for 10 years. A simple math exercise shows actual cash value to be $25,000.

Formula: life remaining (10 years)/useful life (20 years) equals 50% (deduction percentage) x $50,000 (replacement cost).

As general and widespread rule, carriers would like to depreciate as much as possible so that their initial payment (or final payment if the item is never replaced) is less. To the contrary, insureds and their representative (Greenspan) argue for minimal depreciation-- thereby requiring a greater up-front payment. This gives Greenspan’s client the greater option of replacing differently or even not replacing at all.

Arguing depreciation due to age alone can be both easy (simple math calculation) and somewhat difficult, due to differing opinions as to useful life.

It is axiomatic that the task becomes ever more imposing in those jurisdictions and situations where one must also consider the condition of the property and the subjective components of functional and economic obsolescence.

California Rule

California, being as unique as it is, has taken the replacement less depreciation point of view and modified dramatically.

In the Golden State, actual cash value is “…the amount it would cost the insured to repair, rebuild, or replace the thing lost or injured less a fair and reasonable deduction for physical depreciation based upon its condition at the time of the injury…. A deduction for physical depreciation shall apply only to components of a structure that are normally subject to repair and replacement during the useful life of the structure.” (Insurance Code Section 2051; emphasis ours).

Furthermore, “…except for the intrinsic labor costs that are included in the manufactured materials or goods, the expense of labor necessary to repair, rebuild or replace covered property is not a component of physical depreciation and shall not be subject to depreciation….” (CCR Title 10, Chapter 5, Section 2695.9 (f) (1); emphasis ours).

In California, earnest and often contentious discussions of depreciation center around remaining useful life, condition, components normally repaired or replaced, material versus labor costs, and more.

Some Final Thoughts

Why be concerned about actual cash value when replacement cost policies are the norm in this modern era and a full recovery will ultimately be had?

As previously noted, the reasons are several, including:

replacement cost coverage may not be available
replacement cost coverage is optional and comes at an additional premium
replacement cost is not paid until actual repair or replacement has been completed (and costs documented)

This last reason—replacement must first occur—is what makes the negotiation of a larger up-front actual cash value payment so important.

The repair, rebuild, or replacement of damaged property must be of like kind and quality in order to recover the replacement cost benefit. Many carriers apply this condition strictly.

For example, if the house had three bedrooms, some carriers will insist that the replacement should also have three bedrooms. Four bedrooms-- even if the square footage is not increased-- will not fit the bill.

Similarly, if the house was 4,000 square feet, the insurer will typically try to disallow a replacement house of 3,000 feet or two houses of 2,000 square feet each – even if the cost does not differ.

This is where having a knowledgeable, experienced ally like Greenspan is crucial. To revisit an earlier topic (see a prior article on tergiversation and weasel words), the phrase of like kind and quality is the very definition of tergiversation. If the price and square footage are identical, then what is the issue in replacing a three-bedroom house with a four-bedroom house? How far down the rabbit hole do we need to go, and where exactly do we cross over into the absurd—for example, if the walls were painted green in one bedroom, do they need to be painted green in the new house? As you can see, a carrier insisting on the details of a replacement home quickly devolves into purely arbitrary decision-making.

If the insured is able to recover 80-90% (or more) of the replacement cost in advance, they will find less worrisome the like kind and quality requirement and the 10-20% left on the table and have so much more flexibility in how to spend the 80-90%-- including the choice of not even replacing what was lost.Obtaining for our clients as large an actual cash value payment as possible is always one of our goals at Greenspan. By logically arguing the issues of condition and physical depreciation of a limited number of components, Greenspan has been supremely successful in accomplishing this goal—for over 77 years!