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Why Defining Actual Cash Value is Amazingly Difficult

Author: Chris Boggs

Courtroom arguments persist regarding the meaning, application and calculation of actual cash value (AVC). Two key questions generally debated in the ACV argument are:

  1. What does Actual Cash Value mean; and
  2. Can or should labor be depreciated when developing the ACV?

The answer to both questions key off two factors:

  1. The state in which the property is located; and
  2. Whether ACV is defined in the policy. 

All four issues relevant to the development of ACV are discussed in this article. 

Defining Actual Cash Value

Actual cash value is traditionally defined within insurance as “replacement cost less physical depreciation." However, NONE of the industry “standard" property forms promulgated by Insurance Services Office (ISO) define actual cash value. In fact, use of the term “depreciation" in direct relation to the application of ACV disappeared with the release of the 1943 NY Standard Fire Policy. Prior to the 1943 edition, the property form specifically stated ACV contemplated reasonable depreciation. 

ISO-based forms only indirectly infer that the concept of actual cash value employs depreciation. This is true of the commercial property (CP), businessowners' (BOP) and homeowners' (HO) policies where the concept of depreciation is found only in the description of replacement cost. For example, ISO's commercial property policy reads:

3. Replacement Cost 

a. Replacement Cost (without deduction for depreciation) replaces Actual Cash Value in the Valuation Loss Condition of this Coverage Form." 

“Depreciation" is found nowhere else in the commercial property form. This same intimation that ACV is developed by deducting depreciation exists in the BOP and the HO policy. None of ISO's property policies directly define ACV or certify that depreciation is used to develop a property's ACV. Only in the replacement cost wording is the concept of depreciation introduced. 

Here is an interesting question: If a policy does not contain a replacement cost option, would ACV be understood and applied the same as it is now; that is by applying depreciation? 

Depreciation is a primary factor in developing ACV. But like the meaning of ACV, “depreciation" is undefined in ISO property policies. 

Although there are many types of depreciation: obsolescent depreciation; economic depreciation; and accounting depreciation; insurance focuses on physical depreciation. Physical depreciation is somewhat equivalent to “wear and tear" or a property's “useful life." 

According to the finding in Central R. Co. v Martin, physical depreciation is “a constant factor that begins as soon as an asset is exposed to the action of the elements or is put into use." But courts also state that physical depreciation is a function of the condition of the building just prior to the loss, which may not be a constant given the fact that one building owner may make updates and improvements to his building where another might not. 

In essence, the starting point when “divining" depreciation is that wear and tear is a constant, “useful life" factor; but the development of true depreciation is an individualized building-by-building calculation. Ultimately, one 10-year-old building is not equivalent to another 10-year-old building when calculating depreciation percentages. 

Beyond Depreciation

Only nine states define actual cash value to mean replacement cost minus physical depreciation. And two other states apply this rule with another depending on the loss (see the available state comparison spread sheet). Thus, replacement cost minus physical depreciation is a minority position. Two other theories are used far more commonly than replacement cost minus physical depreciation in the development of ACV:

  • The Broad Evidence Rule; and
  • Fair Market Value

The Broad Evidence Rule

Twenty-four states apply the Broad Evidence Rule, making this the most common method for developing ACV. It is exactly what it sounds like; the Broad Evidence Rule applies every factor that bears on the value of property to the development of the ACV including the structures:

  • Market value;
  • Replacement cost;
  • Physical depreciation;
  • Original cost;
  • Useful life factors;
  • Condition of the property;
  • Location;
  • Use;
  • Intended use;
  • Assessed value;
  • “Offer to sell" value; and
  • Offers to purchase amounts. 

Reports are that the Broad Evidence Rule became a favored valuation method for insurance carriers in the 1970s amid a rash of inner-city arsons. Market values were falling precipitously making the difference between the replacement cost less depreciation (traditional ACV) higher than market value (possibly creating a moral hazard). 

One of the earliest cases to apply the Broad Evidence Rule was McAnarney v. Newark Fire Insurance Company. McAnarney purchased an old brewery for $8,000 in 1919 and ultimately insured the property for $60,000 using multiple insurance policies (common for that time); this may have been the appropriate actual cash value limit. 

The buildings were destroyed by fire in April 1920, but the carriers refused to pay the $60,000 (ignoring deductibles). In the jury trial, McAnarney was awarded $55,000. But on appeal, the NY Court of Appeals (NY's highest court) looked at all factors surrounding and applying to the value of the buildings to arrive at a decision. These factors included:

  • Passage of the 18th Amendment on January 16, 1919 (known as prohibition) which made the operations for which the building was constructed illegal;
  • McAnarney admitting the buildings weren't good for anything other than brewing beer; and
  • The fact the insured tried to sell the property, but was not offered more than $6,000.

Applying these facts, the Court of Appeals reversed the lower court stating: 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. This finding essentially created the Broad Evidence Rule.

Fair Market Value

Rarely does the concept of “fair market value" enter into the minds of insurance professionals when defining, or attempting to define, actual cash value. Why? Because market value does not seem to reasonably relate to insurance. 

Fair market value is defined as the amount a willing buyer would pay a willing seller for a piece of property when neither is under duress to buy or sell. Fair market value's primary problem as a factor for developing ACV is clear within this definition – fluctuations in market value. 

Consider the market value of any structure (residential or commercial) in 2007 and compare that value to its market value at the beginning of 2009. If you remember, the US economy tanked in the fall of 2008 and worsened into 2009. A structure that had a market value of $1 million in 2007, could have had a market value of only $700,000 in 2009. 

Nothing changed about the structure; the only difference was the economy. Nevertheless, thirteen states equate ACV with fair market value. Three of these 13 don't apply fair market value as the only method for developing ACV based on specific circumstances:

  • One also uses the Broad Evidence Rule;
  • Two apply replacement cost minus depreciation in some circumstances. 

Other Options

Two states do not allow any difference between ACV and replacement cost (KA and MS); and four states have no statute or common law stipulating any of the presented theories be used to develop ACV. Follow this link to a state-by-state breakdown of theories applied. 

Defining ACV in the Policy

If the policy in question defines actual cash value, or even depreciation, the theories above do not apply. The carrier applies depreciation and calculates actual cash value as defined in the policy. (Provided policy language meets statute – which in theory it should if the forms have been approved.) 

Depreciating Labor

Two factors can affect whether the cost of labor can be depreciated to develop the structure's ACV: 1) the state; and 2) the policy language. Seventeen states apply either statutory or common law to the question of labor depreciation. And in states that have yet to address the issue, it appears, based on anecdotal evidence only, that the standard practice is to depreciate labor until the courts or state direct otherwise. 

But, if policy wording specifically addresses the depreciation of labor within the definition of or description of actual cash value, the policy wording prevails. ISO does not address the depreciation of labor in any of its property forms so such wording if found only in proprietary forms.

Redcorn v. State Farm Fire & Casualty Company is the landmark case that created the dividing-line in the debate surrounding the depreciation of labor. The Oklahoma Supreme Court in Redcorn concluded that depreciation of labor is appropriate under the broad evidence rule. In a 5-3 decision, the majority quoted the McAnarney finding (presented above) and further stated: “The relevant evidence for determining actual cash value for a roof would include cost of reproduction, the age of the roof, and the condition in which it has been maintained. A building is the product of both materials and labor. The age and condition of the building were considered relevant facts…. Likewise, a roof is the product of materials and labor, and its age and condition are also relevant facts in setting the amount of a loss."

The majority further opined: “Despite the objections of Redcorn, indemnity is served by considering the age and condition of a roof, both materials and labor, in setting an amount of loss. To meet the goal of indemnity, Redcorn should be placed, as nearly as practicable, in the same condition as he was in just prior to the insured loss. Pursuant to the broad evidence rule, a fact-finder is entitled to consider what the life of the destroyed roof, both materials and labor, would have been, as well as any other relevant evidence presented."

But as was mentioned, there were three dissenting opinions. These dissenting judges write:

“I reject the majority's characterization of Redcorn's roof as a single product. A roof, unlike a preassembled consumer good, is not an integrated product. Redcorn cannot go the lumber yard or the retail store and buy a roof. A roof does not exist until the shingles are transported to the site and installed on top of the house. A roof is not a unified product but a combination of a product (shingles) and a service (labor to install the shingles).

The shingles are of course logically depreciable. As they age, they certainly lose value due to wear and tear. They typically have a useful life of twenty years. It makes sense, then, that sixteen-year-old shingles have lost sixteen/twentieths, or eighty percent, of their value over time.

Labor, on the other hand, is not logically depreciable. Does labor lose value due to wear and tear? Does labor lose value over time? What is the typical depreciable life of labor? Is there a statistical table that delineates how labor loses value over time? I think the logical answers are no, no, it is not depreciable, and no. The very idea of depreciating the value of labor is illogical.   The image that comes to me is that of a very old roofer with debilitating arthritis who can barely climb a ladder or hammer a nail. The value of his labor, I suppose, has depreciated over time." 

Another judge stated:

“To properly indemnify Redcorn, State Farm should pay him the actual cash value of the shingles, depreciated for wear and tear, plus the cost of their installation. In my view, allowing State Farm to depreciate the cost of labor would leave Redcorn with a significant out-of-pocket loss, a result that is inconsistent with the principle of indemnity."

And the last dissenting opinion reads, in part:

“Before the damage the insured had on his house a roof with sixteen-year-old shingles. After the damage the insured is contractually entitled to have on his house sixteen-year-old shingles, or their value in money. He should not bear any of the cost of installing them, because that would deprive him of that for which he contracted - being made whole as if the damage had not occurred."

Since this March 12, 2002, finding, courts have continued to decide on both sides of this issue. Some courts agree with the majority opinion in Redcorn; but others agree with the dissenters. Even the National Association of Insurance Companies (NAMIC) has taken a stance:

  • ​​NAMIC believes that insurers should be able to able to provide actual cash value coverage that includes depreciation of labor costs. Ensuring that coverage is provided based on reasonably anticipated costs allows insurers to provide consumers with lower cost options when buying insurance. 

NAMIC has supported the position that the cost of labor may be depreciated in calculating actual cash value in a number of amicus curiae briefs and has supported legislation responsive to contrary holdings by courts and regulators. 

The VU has attempted to compile a state-by-state synopsis of where each state falls in regard to the depreciation of labor when calculating ACV. As mentioned earlier, only 17 states have statutory or common laws in place regarding depreciation of labor. Eleven of the 17 states do not allow the depreciation of labor – at least some of the time; and six allow the depreciation of labor in at least some circumstances.

Bringing This Together

Because neither ACV nor depreciation are defined in any ISO property policy, the “same" loss in two or several different states can result in different valuations and ACV payments based on:

  • Which of the four rules or guidelines for determining ACV the state uses; and
  • Whether labor can or cannot be depreciated in that state.

These variations seem as though they disappear if/when the policy in question defines ACV or specifically addresses what can and cannot be depreciated. Should ACV be defined? Should labor be subject to depreciation? What are your thoughts?

Last Updated: February 1, 2019​​

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