Commercial Property

# Depreciation of Labor in Calculating ACV: Yes or No?

| July 26, 2024

A windstorm damages your insured's roof, and your insured receives an estimate of \$25,000 to replace it, a sum the insurer believes is reasonable. If the insured carries property insurance with replacement cost coverage and replaces the roof, one would expect the insured to receive a payment of \$25,000 less the deductible.

But what if the insured does not have replacement cost coverage on the roof because the policy is written on an actual cash value (ACV) basis? Or perhaps, just the roof is valued at ACV because the insurer used an increasingly common endorsement, Limitations on Coverage for Roof Surfacing (CP 10 36 10 12), to amend the valuation. Yet another possibility is that the insured carries replacement cost coverage but has not notified the insurer of the intent to make a replacement cost claim within the period allowed by the policy. In that case, recovery is limited to ACV. So, what is the ACV of the roof in our example?

Depending on policy language and the jurisdiction, there are various ways that ACV can be determined. Let's assume for a moment that coverage is written using the Insurance Services Office, Inc. (ISO), Building and Personal Property Coverage Form (CP 00 10 10 12), which does not define ACV. Absent a definition, in some states, ACV is equal to the fair market value of the property. Many states use a broad evidence rule approach where myriad factors are considered, including, for example, market value, useful life, condition of the property, location, use, and depreciation. A few states even use the approach most new insurance practitioners are taught: ACV is replacement cost at the time of loss minus depreciation.

Depreciation is a factor in most approaches to calculating ACV. But what should be depreciated? The cost of the roof is made up of labor and materials. One can easily see that the materials are subject to physical depreciation, but what about the labor? This is where things get interesting, and it can make a big difference.

#### Calculating ACV

The replacement cost of the roof is \$25,000: \$12,500 material + \$12,500 labor.

The roof has a useful life of 20 years and is 10 years old. It has depreciated 50 percent.

We will use ACV = replacement cost minus depreciation as the definition for this example.

ACV with materials and labor depreciated is \$12,500.

• \$25,000 less 50 percent depreciation

ACV with materials depreciated, but no depreciation of labor is \$18,750.

• \$12,500 material less 50 percent depreciation = \$6,250
• Plus \$12,500 labor

## What Does the Policy Say?

When faced with a coverage question, the first stop is always the policy language. Most commercial property forms do not include a definition of ACV. Of those that do, most do not describe how depreciation applies. The following example uses language from an endorsement defining ACV. Like many, it includes no information on what should be depreciated.

#### Pennsylvania Changes—Actual Cash Value

The following is added to any provision which uses the term actual cash value:

• Actual cash value is calculated as the amount it would cost to repair or replace Covered Property, at the time of loss or damage, with material of like kind and quality, subject to a deduction for deterioration, depreciation and obsolescence. Actual cash value applies to valuation of Covered Property regardless of whether that property has sustained partial or total loss or damage.

The actual cash value of the lost or damaged property may be significantly less than its replacement cost.

Source: ISO Properties, Inc., Pennsylvania Changes—Actual Cash Value (IL 01 66 09 07), © 2006.

Contrast that with the language in the following example. The policy that includes this language clearly states that ACV considers only physical depreciation of certain components of the building or structure. In this case, labor would not be depreciated when calculating ACV.

#### Sample Policy Language—Labor Not Depreciated

Actual cash value is calculated as the lesser of the following:

1. The amount it would cost to repair, rebuild or replace the property less a fair and reasonable deduction for physical depreciation of the components of the building or structure that are normally subject to repair or replacement during its useful life. Physical depreciation is based upon the condition of the property at the time of the loss; or
2. The Limit of Insurance applicable to the property.

The insurer that created the next form is also clear about its intention: It will depreciate labor costs when calculating ACV.

#### Sample Policy Language—Labor Depreciated

Actual cash value means the cost to repair or replace property with new materials of like kind and quality, less an adjustment for physical depreciation, deterioration, obsolescence and depreciation of the cost of labor associated with the repair or replacement of covered property at the time of loss. [Emphasis added.]

For policy language to take a clear position on this issue is the exception and not the norm. Assuming that we are left without guidance from the policy, how should the issue be resolved?

## What Does the State Say?

Same states have statutes addressing this question. In California, labor costs are not subject to depreciation. California Insurance Code § 2051(b) states, in part:

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 that structure.

Washington is another state where labor costs are not depreciated. Effective January 1, 2022, Wash. Admin. Code § 284-20-010 (4) states:

Except for the intrinsic labor costs that are included in the cost of manufactured materials or goods, the expense of labor necessary to repair, rebuild, or replace covered property is not a component of physical depreciation and may not be subject to depreciation or betterment.

Another place to find an answer is to look at insurance department regulations or directives. For example, the Vermont Department of Financial Regulation, in its Insurance Bulletin No. 184, states:

It is the Department's position that depreciation of labor costs is prohibited by 8 V.S.A. § 4724(9)(F) 1 and is therefore an unfair claim settlement practice…. While the value of the property as a whole may be considered in order to put a claimant in the same position as the claimant was before the loss occurred, labor of any kind related to the repair, rebuilding or replacement of covered property should not be subject to depreciation.

Although the statute referenced does not directly address depreciation of labor, the state has interpreted the statute as respects this issue.

If neither state statutes nor a state's insurance department has addressed the question, one can look for case law in the jurisdiction. As is often the case with property coverage issues, many of the court cases involve homeowner policies, rather than commercial property policies, but the coverage question is the same.

## Case Law—Labor Can Be Depreciated

Some courts have ruled that, absent specific policy language, labor can be depreciated. This case from Colorado involved a policy that defined ACV as "the amount it would cost to repair or replace covered property, at the time of loss or damage, with material of like kind and quality, subject to a deduction for deterioration, depreciation and obsolescence." The policy did not, though, address depreciation of labor. The court's reasoning is clear:

Covered property, such as a roof, is often the product of both materials and labor. Accordingly, repair and replacement costs comprise the cost of materials (e.g., shingles and nails), and the cost of labor (e.g., roofing contractors). Both the cost of materials and the cost of labor are therefore subject to a depreciation deduction.

Basham v. United Servs. Auto. Ass'n, Civil Action No. 16-cv-03057-RBJ, 2017 U.S. Dist. LEXIS 118729 (D. Colo. 2017).

The court went on to support its position through use of an analogy involving a piano:

Suppose that a person wants to buy a grand piano. The piano materials themselves—wood, metal, and the like—may have a value of only \$500. But building a piano requires great skill and hours of labor. Because of this labor, the value of the finished piano is \$5,000. The labor has increased the price of the finished good, and it has merged into part of a completed product. And as this finished good—the piano—depreciates in value, the value of the labor that went into building it depreciates as well.

A similar result is found in this case applying Kansas law to a claim involving damage to a kitchen that was not repaired. This policy included a definition of ACV much like the one in the Colorado case just discussed.There is an additional concern raised here by the court:

If American Family could depreciate only the cost of materials in determining the actual cash value of Graves' loss, she would receive a windfall based on labor costs she never incurred.… Such a result is contrary to the principle of indemnity because she would be in a better position than she was before the damage occurred.

Graves v. American Family Mut. Ins. Co.,686 Fed. App'x 536 (10th Cir. 2017).

## Case Law—Labor Cannot Be Depreciated

Some courts have decided differently. If a policy does not specifically allow for depreciation of labor, then labor cannot be depreciated.

In this Missouri case, the policy defined ACV as "the amount it costs to repair or replace property with property of like kind and quality less depreciation for physical deterioration and obsolescence." The court ruled that:

The phrase "for physical deterioration and obsolescence" limits the type [of] depreciation that may be factored into a calculation of "actual cash value."

Riggins v. American Family Mut. Ins. Co.,106 F. Supp. 3d 1039 (W.D. Mo. 2015).

In other words, labor is not subject to physical deterioration, so it cannot be depreciated.

## Case Law—Some Labor Can Be Depreciated

There is one other possible answer to the question of whether labor can be depreciated: the idea that some labor can be depreciated. In this case from Oklahoma, the insured's roof was damaged and needed replacement. The policy included an endorsement valuing roof claims at ACV, defined as "replacement cost less depreciation." The court defined replacement cost as "the sum of those costs an insured is reasonably likely to incur in replacing his covered loss."

With respect to the labor cost to construct the new roof, labor costs are subject to depreciation. The court ruled:

Labor costs may be depreciated when using the replacement costs less depreciation method.

Branch v. Farmers Ins. Co., 311 F.3d 1241 (10th Cir. 2002).

The answer was different, though, when the labor costs to tear off the damaged roof were considered. In this case, the court ruled that:

Tear off of the old roof is not included as a necessary part of the replacement costs of installing a new roof.… Removing damaged materials, and materials that have to be removed as a result of storm damage to the roof in order to install the new roof, must all be treated as rubble, or in the contract language, debris.… The debris removal clauses in the insurance policies … do not mention depreciation. Therefore, the labor costs in debris removal may not be depreciated.

Ibid.

## Conclusion

Whether depreciation of labor costs is appropriate when ACV valuation applies to a claim is not commonly addressed in insurance policies. If the policy language does not address the issue, one should look to state statutes and interpretations from state insurance departments. Lastly, case law in a jurisdiction may address the question. In many states, though, there is no relevant authority, so the question of whether labor should be depreciated remains an open one.

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Footnotes

1 8 V.S.A. § 4724 (9) Unfair claim settlement practices. Committing or performing with such frequency as to indicate a business practice any of the following: (F) not attempting in good faith to effectuate prompt, fair, and equitable settlements of claims in which liability has become reasonably clear.