Property and Casualty Insurance—To Repair or Replace
September 2009
At recent conference, I had the
privilege of attending a lecture which discussed some repair versus
replacement valuation issues encountered when reviewing property
and casualty claims. This topic was of interest to me, in particular,
relating to certain large loss claims where we were asked to assist
our client in making the determination of whether to repair or replace
a damaged structure or piece of equipment.
by
Paul D. Haynes, CPA/ABV, CFF
SMART Business Advisory and Consulting, LLC
The basics surrounding repair versus replacement in a property
and casualty insurance context seem pretty simple. Specifically,
in a replacement cost policy, the insurer will pay the lesser of
either the cost to repair the item or the cost to replace, new for
old, without consideration of depreciation. The value would be limited
to the actual amount expended to repair or replace the damaged equipment
with comparable materials and quality. Further, the potential recovery
would be limited to the actual property that is repaired or replaced,
within a reasonable period of time following the loss.
As is often the case, there are certain instances where a particular
circumstance or set of circumstances can obscure what would otherwise
be cut and dry. These circumstances can be the result of legal challenges
initiated by the insured, from changes to applicable building codes,
safety regulations, or other ordinances or laws.
To Repair or Not To Repair?
Several questions arise in the course of conducting this work,
such as in response to a challenge initiated by the insured. Must
it be shown that the repairs attempted by the insurer actually restored
the damaged property to its pre-loss condition and with the same
degree of serviceability? If so, what standard of repair is the
insurer held to? In this instance, the restoration would entail
bringing the damaged property back to pre-loss condition for functional
usefulness, practical utility, and purpose—however, not monetary
worth or value. Further, from whose perspective are these assessments
made, the insured, the insurer, or a third party?
Typically, the standard applied is that of a hypothetical reasonable
person. In this instance, the reasonable person would also be well
informed as to the industry in which the insured operates. Factors
that should be considered in the determination of whether repair
is the appropriate measure of recovery are the after repair capacity,
capability, reliability, and safety of the property. In addition,
the future insurability, operational costs and lifespan would also
be weighed in the determination of repair versus replace.
Repair Considerations
Considering all of these factors, oftentimes the repair option
is the most likely course of action. However, other factors must
also be considered, such as any applicable code requirements and/or
the cost/benefit of repairing older equipment such as computers.
The question is whether it is possible to repair outdated, inefficient
equipment of similar quality in today's market.
Further, many local ordinances may dictate a specific percentage
of a structure that can be repaired, and any repair beyond that
percentage would require the replacement of the structure. Consider
the occurrence of a fire at a manufacturing facility that destroyed
25 percent of the roof, whereas the undamaged section of roof is
a number of years old, and not in sound condition. Considering these
situations, may the insured make a claim for replacement for of
a structure or machine that is at or near the end of its useful
life? Specifically, does the insurance contract stipulate that in
certain circumstances the insurer agrees to pay replacement cost
for machinery or structures at or near the end of their useful life?
Is it intended that the cost and recovery of both repair and replacement
be available based on the extent of damage to the machinery or equipment
following a covered loss? Further, what if the insured had plans
prior to the loss to replace or upgrade the equipment, and who bears
the burden to prove that the damaged property is repairable?
Time Element Considerations
While many of the scenarios above speak more directly to questions
of coverage law, there are times where more practical considerations
come into play. This would be where the time element components
of the claim affect the repair-versus-replace equation. In instances
where the covered loss and the resulting damage to the equipment
or structure is accompanied by a business income and/or extra expense
claim, the costs of both portions of the claim must be aggregated
for final determination of the recoverable loss.
The factor to consider is the monetary impact that either course
of action has on the time element portion of the claim, specifically
the period of restoration. In particular, if the insured has claim
for a business income loss and or extra expense, the additional
costs associated with an extended period of restoration must be
weighed against the cost of repair versus replacement.
When considering a business income loss, the difference between
one option over the other must reduce the amount of the business
income loss by an amount greater than what would otherwise by recoverable.
The same would hold true in an extra expense scenario where the
decision to repair versus replace would be weighed against extra
expenses incurred by insured. In this situation, the incremental
costs incurred in a particular course of action must reduce the
recoverable loss by an amount greater than what would have otherwise
been recovered through a mitigation of the insured's loss.
Conclusion
The examples noted above detail just a small percentage of many
scenarios one can encounter in the evaluation of property and casualty
claim for either real or business personal property. One take-away
from the lecture I referenced above is that anything can be repaired;
it's just a matter or how much reserve engineering you want to put
into it. However, if you are considering paying repair costs, be
prepared for a variety of potential challenges.
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