Tennessee Supreme Court Holds That Replacement Cost Less Depreciation Does Not Allow for Depreciation of Labor When Calculating Actual Cash Value of a Property Loss

Heidi Hudson Raschke | Property Casualty Focus | May 2, 2019

Insurance policies are designed to indemnify an insured by putting the policyholder in the same position he or she would have been in had no loss occurred. In the context of property insurance policies, damaged property is typically valued based on its estimated actual cash value (ACV) if it is not repaired or replaced. In order to calculate ACV, an insurer will often calculate the replacement cost (RCV) based on the cost to repair or replace the property with materials of like kind and quality, and then depreciate that amount to account for age, wear, obsolescence, or market value. When making that calculation, there can be a question as to whether labor should be appreciated. In Lammert v. Auto-Owners (Mutual) Insurance Co., No. M2017-02546-SC-R23-CV (Tenn. Apr. 15, 2019), the Supreme Court of Tennessee joined the states that have ruled that labor cannot be depreciated.

To Depreciate Labor or Not

In this case, the petitioners filed a putative class action seeking a ruling that Auto-Owners impermissibly depreciated labor when calculating ACV under certain homeowners policies. When calculating ACV, Auto-Owners acknowledged that it depreciated both materials and labor.

There were two policies at issue. One defined ACV as “the cost to replace damaged property with new property of similar quality and features reduced by the amount of depreciation applicable to the damaged property immediately prior to the loss.” The second policy did not define ACV, but stated that actual cash value includes a deduction for depreciation. The policyholders argued that these definitions do not allow for depreciation of labor “because labor is intangible, and ‘prior to the loss’ likewise eliminates labor costs because the labor costs at issue are post-loss costs.” The policyholders also pointed to the definition of “depreciation,” which was defined as “a decrease in value because of age, wear, obsolescence or market value,” to argue that labor cannot be depreciated “because it does not age, wear out, become obsolete, or (generally speaking) decrease in market value.” In response, Auto-Owners argued that the policies are not ambiguous and “that depreciation of a property is taken from the total replacement cost, which includes both labor and materials.”

The district court determined that the dispute over whether labor can be depreciated is a question of state law for which there was no controlling precedent, and certified the following question to the Tennessee Supreme Court:

Under Tennessee Law, may an insurer in making an actual cash value payment withhold a portion of repair labor as depreciation when the policy (1) defines actual cash value as “the cost to replace damaged property with new property of similar quality and features reduced by the amount of depreciation applicable to the damaged property immediately prior to the loss,” or (2) states that “actual cash value includes a deduction for depreciation”?

The Question of Indemnity

The question of coverage is always determined by the policy terms and conditions. Insurance policies are interpreted based on their plain language. However, if the language at issue is susceptible to more than one reasonable interpretation, a policy will be considered ambiguous and is most often construed in favor of the insured and coverage.

The Tennessee Supreme Court noted that “[c]entral to the discussion in this opinion are the concepts of indemnity, actual cash value, and depreciation.” Insurance policies, as contracts of indemnity, are intended “to reimburse the insured; to restore him as nearly as possible to the position he was in before the loss” (quoting Braddock v. Memphis Fire Ins. Corp., 493 S.W.2d 453, 459-60 (Tenn. 1973)). When property is damaged, “if an insured were able to replace a loss ‘with a substitute identical in kind and quality’ then ‘complete indemnity’ would be accomplished” (quoting McAnarney v. Newark Fire Ins. Co., 159 N.E. 902, 904 (N.Y. 1928)). Because such substitution is often not possible, “indemnity is instead accomplished through recovery of the actual cash value of a damaged property.”

The court observed that there are several methods for calculating ACV, including market value, replacement cost less depreciation, and the broad evidence rule. In this case, the parties agreed that the method for calculating ACV was replacement costs less depreciation.

What they disagree on is whether depreciation applies only to the materials or to both materials and labor. The homeowners claim that applying depreciation to both materials and labor defeats the indemnity purpose of insurance by not making the homeowners whole, while Auto-Owners counters that applying depreciation only to materials results in a windfall to the homeowners, thus also defeating the purpose of indemnity.

The court reviewed decisions from around the country that have come down on either side of the question presented. Some courts find that labor cannot be depreciated. See, e.g., Titan Exteriors, Inc. v. Certain Underwriters at Lloyd’s, London, 297 F. Supp. 3d 628 (N.D. Miss. 2018); Arnold v. State Farm Fire & Cas. Co., 268 F. Supp. 3d 1297 (S.D. Ala. 2017); Brown v. Travelers Cas. Ins. Co. of Am., No. 15-50-ART, 2016 WL 1644342 (E.D. Ky. Apr. 25, 2016); Lains v. Am. Family Mut. Ins. Co., No. C14-1982-JCC, 2016 WL 4533075 (W.D. Wash. Feb. 9, 2016). Other courts find that labor can be depreciated, or at least that the depreciation of labor can be considered when determining ACV. See, e.g.Graves v. Am. Family Mut. Ins. Co., 686 F. App’x 536 (10th Cir. 2017); In re State Farm Fire & Cas. Co., 872 F.3d 567 (8th Cir. 2017); Henn v. Am. Family Mut. Ins. Co., 894 N.W.2d 179 (Neb. 2017); Redcorn v. State Farm Fire & Cas. Co., 55 P.3d 1017 (Okla. 2002). In addition, “[t]he Minnesota Supreme Court took a third approach to answering the issue by determining that the depreciation of labor costs is an issue of fact rather than law” (citing Wilcox v. State Farm Fire & Cas. Co., 874 N.W.2d 780, 785 (Minn. 2016)).

The court noted that the most recent appellate court to address the issue was the Sixth Circuit Court of Appeals in Hicks v. State Farm Fire & Casualty Co., 751 F. App’x 703 (6th Cir. 2018). In that case, “the Sixth Circuit concluded that under Kentucky law, the term ‘actual cash value’ was ambiguous, not because it was undefined but because the word ‘depreciation’ as used in the statutory definition of ‘actual cash value’ was itself ambiguous.” The court based this finding of ambiguity on the fact that the parties presented two reasonable interpretations of the word depreciations — one allowing depreciation of both labor and materials, and one allowing depreciation of materials only. The Sixth Circuit found that those cases allowing depreciation of both labor and materials were typically in states following the broad evidence rule for determining ACV.

While Auto-Owners argued that Tennessee is a broad evidence state, the Supreme Court stated that it had never adopted the broad evidence rule. Rather, it had “merely acknowledged that the broad evidence rule and the replacement-cost-less-depreciation method both accomplished indemnity.” Moreover, the court determined that whether Tennessee is a broad evidence state is not at issue since the parties agreed that actual cash value was to be calculated based on the replacement cost method.

Turning to general principles for interpreting insurance contracts, the Tennessee Supreme Court found that “both parties have presented plausible interpretations of the policies, neither of which explicitly states whether labor expenses are depreciable when calculating the actual cash value.” The court decided that Auto-Owners argued for a “technical definition” of depreciation that is not evident on the face of the policies, while taken in its “ordinary sense” depreciation means “physical depreciation,” which is the meaning that the court found had been attributed to it by the policyholders. As a result of its determination that the provisions were susceptible to more than one reasonable interpretation, the court found the provisions ambiguous and construed them in favor of the insured, holding that “depreciation can only be applied to the cost of materials, not to labor costs.”

Auto-Owners argued “that if the homeowners’ interpretation is correct, then indemnity is not accomplished because instead of receiving the actual value of their property in terms of money, the insured would never receive less than the cost of the labor, even if the labor was worth more than the actual property prior to the loss.” In contrast, the policyholders argued that “depreciating labor costs would underindemnify the insureds because they would bear the out-of-pocket costs of reinstalling the damaged asset.” The court did not address the indemnification dispute holding:

Ultimately, it is not necessary for this Court to reach the decision of whether labor can logically depreciate or whether indemnity is accomplished. It is enough that we find the contracts ambiguous and that under our standard of review, the interpretation of the insured must prevail. We conclude that the answer to the district court’s certified question is no, the insurance company cannot withhold a portion of the labor costs as depreciation under either policy.

Unanswered Questions

As an initial matter, it is worth noting that this decision left open the question of whether Tennessee is a broad evidence state. The regulations promulgated by the Tennessee Department of Insurance further leaves this question open. While it provides that “[w]hen the insurance policy provides for the adjustment and settlement of losses on an actual cash value basis on residential fire and extended coverage, the insurer shall determine actual cash value as follows: replacement cost of property at time of loss less depreciation, if any,” it also states that “[i]n cases in which the insured’s interest is limited because the property has nominal or no economic value, or a value disproportionate to replacement cost less depreciation, the determination of actual cash value as set forth above is not required.” Tenn. Comp. R. & Regs. 0780-01-05-.10(2) (effective Oct. 2017). Giving an insurer an alternative to calculating ACV, when replacement cost less depreciation does not seem to provide an appropriate valuation, suggests that broad evidence can be considered in at least some instances in Tennessee.

The case also arguably leaves open the question of whether labor can be depreciated if an insurance policy specifically defines depreciation as including the depreciation of labor. In this decision, the court noted multiple times in reaching its decision that the policies did not state whether labor expenses could be depreciated. Without controlling language in the policy, the court held that the insurance provisions were susceptible to more than one interpretation, making them ambiguous and construed in favor of the insured and coverage. If, however, the policy defined depreciation as including labor, it is not clear from the face of the opinion that such a provision would not be upheld. Again, the scope of coverage should be governed by the specific language of the policy.

Statutory Interest Series: Michigan

Beaujeaux de Lapouyade | Property Insurance Coverage Law Blog | May 16, 2019

Prompt-pay laws are important to a policyholder’s rights to recover insurance benefits following a wrongful denial or delay in payment of a property damage claim. Prompt-pay laws vary from state to state. The implementation of statutory prompt-pay laws is critical to a policyholder’s recovery following a devastating loss.

A policyholder’s entitlement to prejudgment interest on wrongfully delayed or denied claim payments is a necessary tool to encourage insurance carriers to properly investigate claims and issue payments in a timely manner.

The State of Michigan enforces statutory interest penalties for a carrier’s failure to issue payments promptly. The Michigan State Legislature enacted prompt-pay laws to protect consumers from delayed payment of owed policy benefits.

Michigan’s Prejudgment Interest Statute1 allows interest on any money judgment recovered in a civil action and calculated from the date of filing the complaint at 6% per year.

In addition, claims not paid timely will constitute an unfair trade practice unless the claim is “reasonably in dispute.” The statute provides as follows:

Mich. Comp. Laws §500.2006. Payment of benefits on timely basis; payment of interest in alternative; failure to pay claims or interest as unfair trade practice.

(1) A person must pay on a timely basis to its insured, a person directly entitled to benefits under its insured’s insurance contract . . . or, in the alternative, a person must pay to its insured, a person directly entitled to benefits under its insured’s insurance contract . . . 12% interest, as provided in subsection (4), on claims not paid on a timely basis. Failure to pay claims on a timely basis or to pay interest on claims as provided in subsection (4) is an unfair trade practice unless the claim is reasonably in dispute.

The last sentence of subsection (1) tells us that we should also consider the language of subsection (4), which provides:

(4) If benefits are not paid on a timely basis, the benefits paid bear simple interest from a date 60 days after satisfactory proof of loss was received by the insurer at the rate of 12% per annum, if the claimant is the insured or a person directly entitled to benefits under the insured’s insurance contract. . . . The interest must be paid in addition to and at the time of payment of the loss. If payment is offered by the insurer but is rejected by the claimant, and the claimant does not subsequently recover an amount in excess of the amount offered, interest is not due. Interest paid as provided in this section must be offset by an award of interest that is payable by the insurer as provided in the award.

Policyholder’s should be mindful of subsection (4) above, which notes that interest is not payable on payments offered by the carrier and rejected by the policyholder if the policyholder subsequently fails to recover an amount more than the offered amount.

In Denham v. Bedford,2 the Michigan Supreme Court confirmed that Michigan’s Prejudgment Interest Statute is a “remedial statute entitled to liberal interpretation.” In Denham, the court determined that carriers owe interest to the policyholder on the entire judgment regardless of whether the interest owed allows the total payment to exceed policy limits. A noteworthy portion of the opinion provides:

Payment of prejudgment interest not only compensates the prevailing party but also liability for prejudgment interest may act as an incentive to the insurer to promptly settle a meritorious claim. Without such an incentive, the insurer may refuse to settle a meritorious claim in hopes of forcing plaintiff to settle for less than the claim’s true value. The insurer risks nothing. Even if protracted litigation results, the insurer will only be liable for its policy limits all the while reaping a tidy sum from its investment of the policy limits.

Delay tactics are a real burden many policyholders face when dealing with property damage claims. It is important to be aware of the various tools available to assist policyholders in efficiently obtaining full payment of owed policy benefits.
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1 M.C.L.A §600.6013.
2 Denham v. Bedford, 287 N.W.2d 168, 528 (Mich. 1980).



Eleventh Circuit Rules That Insurer Must Defend Contractor Despite “Your Work” Exclusion, Where Damage Timing Unclear

Michael S. Levine | Hunton Andrews Kurth | April 16, 2019

The Eleventh Circuit has reversed an insurer’s award of summary judgment after finding that uncertainty about when the alleged property damage occurred raised questions about whether the damage came within the scope of the “Your Work” exclusion. More specifically, the court found unclear whether the damage occurred before or after the contractor abandoned the job, thereby triggering an exception to the “Your Work” exclusion for damage to work that had “not yet been completed or abandoned.” The decision illustrates how timing can be a critical factor when it comes to triggering coverage for work and completed operations.

In Southern-Owners Insurance Company v. MAC Contractors of Florida, LLC, a pair of trustees hired MAC Contractors (doing business as KJIMS Construction) to serve as the general contractor for a custom residence. After construction began, disputes between the trustees and KJIMS caused the contractor to abandon the job before completing the project. The trustees followed with a lawsuit alleging, among other things, that KJIMS had damaged wood floors and a metal roof, which KJIMS had promised to remediate but never did.

KJIMS’s general liability insurer, Southern-Owners, initially agreed to defend the lawsuit, but later withdrew its defense citing the policy’s “Your Work” exclusion. The insurer sought a declaration that the policy’s “Your Work” exclusion barred coverage because the alleged property damage arose out of KJIMS’s abandoned work. According to its terms, the “Your Work” exclusion bars coverage for “property damage to your work arising out of it or any part of it and included in the products-completed operations hazard.” The “products-completed operations hazard” was defined to mean all “bodily injury and property damage occurring away from premises you own or rent and arising out of your product or your work except . . . [w]ork that has not yet been completed or abandoned.”

On summary judgment, the district court agreed with the insurer and held that the exclusion barred coverage for property damage once the insured abandons the project on which it was working. But on appeal, the Eleventh Circuit reversed. The panel reasoned that the exclusion does not bar coverage for property damage that occurs before an insured’s work has been abandoned. The court then held that although the complaint alleged that KJIMS abandoned its work, the complaint did not clearly allege when the property damage occurred and could be reasonably construed to allege that the damage occurred before KJIMS abandoned the work. As a result, the Eleventh Circuit held that the exclusion did not clearly bar coverage and, thus, the insurer had a duty to defend.

It is widely understood that policy-based ambiguities often result in a construction favoring the insured and coverage. However, factual ambiguities in the claim itself may also result in sufficient uncertainty to trigger an insurer’s duty to defend, even against unambiguous policy language, since the insurer must defend if there is a potential for coverage. The timing of critical events is one area that is especially susceptible to factual uncertainty. Insureds should therefore pay close attention to the alleged timing of such events and be ready to hold their insurers to their broad duty to defend.

Hidden Damage from Wildfire Claims

Derek Chalken | Property Insurance Coverage Law Blog | April 4, 2019

Losses from wildfires across the United States over the past decade have added up to $5.1 billion.1 In addition to damage typically expected from fires (smoke, soot, ash, water from fire-fighting hoses and extinguisher chemicals), some homeowners may face the additional risk of damage caused by suppression efforts, specifically aviation-based firefighting.

Since 2006, CAL FIRE’s Air Program has utilized converted DC-10 planes as its preferred method of fire suppression. DC-10s can carry almost 12,000 gallons of water (or fire retardant).2 Some public entities use a Boeing 747 aerial firefighter, that can carry 24,000 gallons through a pressurized drop system.3 California started using this plane in 2009 to fight the Oak Glen Fire in San Bernardino County.

The results of aerial firefighting are effective but can be just as dangerous and damaging to structures as the fire itself. While dramatized, the 2017 film “Only the Brave” depicted an airtanker missing its mark and destroying a structure while fighting a forest fire:

When the tankers utilize red fire retardant (the U.S. Forest Service uses a non-toxic product known by the brand name Phos-Chek),4 homeowners are faced with a sticky, but generally cleanable mess. However, when aerial firefighting is used in suburban areas, the damage to homes may be hidden, but is also devasting. The force of the water hitting the home can split rafters and severely damage wood shake roofs, including sheathing and felt. While water intrusion through pipe jacks and roof flashing will show obvious interior damage, structural damage may not be visible to the naked eye and could require structural inspections in hard to reach attic areas. If your property has been the unexpected victim of aerial firefighting, make sure to have these areas inspected while adjusting your claim.
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1 https://www.iii.org/fact-statistic/facts-statistics-wildfires
2 http://www.10tanker.com/general/
3 https://www.popsci.com/military-aviation-amp-space/article/2009-06/firefighting-supertanker-dumps-20500-gallons-water-500-feet#page-6
4 https://www.desertsun.com/story/news/local/2018/08/15/what-makes-up-red-fire-retardant-being-dropped-wildfires/987754002/

Applying Depreciation in California – Understanding the Guidelines

Victor Jacobeills | Property Insurance Coverage Law Blog | March 26, 2019

The California Insurance Code mandates if a property insurance policy requires actual cash value payment, the payment must be based on the property’s depreciation for two types of claims: (1) a partial loss to a structure, i.e., a home or building and (2) damaged contents, i.e., personal property or business personal property.1 Fortunately, there is guidance on how depreciation is applied. Cal. Ins. Code § 2051 states actual cash value is the amount it would cost the insured to repair, rebuild, or replace the damaged property less a fair and reasonable deduction for physical depreciation based upon the property’s condition at the time of the injury or the policy limit, whichever is less.

The California legislature is currently debating legislation, Assembly Bill 188, that would require an insured be paid in the same manner for the total loss of a building, as an insured is paid for a partial loss of a building, i.e., for the building’s actual cash value.

Cal. Ins. Code § 2051 and Cal. Code Regs. tit. 10, § 2695.9, set forth parameters on depreciation application and require that depreciation reflect damaged property’s actual condition at the time of a loss. Under Cal. Ins. Code § 2051, physical depreciation can only be applied to the components of a structure that are normally subject to repair and replacement during the useful life of that structure. Under this statute, an insurer can only apply depreciation to building components that are expected to actually suffer wear and tear. The threshold question before depreciation can be applied is whether the component is normally replaced by the home or building owner. If it is not a component that is replaced, what is the extent of maintenance necessary to keep the component in a good condition? For example, a building’s foundation, structural elements, walls and piping are usually not replaced and it is therefore improper to apply any depreciation. It is also improper to apply depreciation to any cost in a building repair estimate that does not relate to building property. Thus, an insurer cannot make depreciation deductions for labor, plans, permits, overhead and profit. If a building component requires minimal maintenance, then the amount of depreciation that can be applied should be limited. For example, a brick wall will probably never be replaced, but it could be subject to some maintenance every ten to twenty years.

California also requires that depreciation cannot be applied based solely on a building component’s age. California insurance regulations mandate that any adjustment for depreciation must reflect the measurable difference in market value attributable property’s age andcondition.2 Consequently, depreciation must be based on the actual condition of the damaged property. Factors that should be considered include how the insured maintained the property, when was the building component last replaced and what was the quality of the property or component. If you can substantiate the property was in good to excellent condition, then you can substantiate minimal depreciation deductions.

Based on California’s depreciation guidelines, in order to correctly evaluate the proper amount of depreciation to apply, it is very important to asses and evaluate the condition of the property prior to the loss. This includes gathering as much information from an insured whether through photos, the insured’s contractors or detailed oral information. This information will assist in minimizing and correctly assessing depreciation.
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1 Cal. Ins. Code § 2051.
2 Cal. Code Regs. tit. 10, § 2695.9.