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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