New ISO ACV Definition and California Statute

The statute, California Insurance Code § 2051 provides:

• (a) Under an open policy, the measure of indemnity in fire insurance is the expense to the insured of replacing the thing lost or injured in its condition at the time of the injury, the expense being computed as of the time of the commencement of the fire.

• (b) Under an open policy that requires payment of actual cash value, the measure of the actual cash value recovery, in whole or partial settlement of the claim, shall be determined as follows:

• (1) In case of total loss to the structure, the policy limit or the fair market value of the structure, whichever is less.

• (2) In case of a partial loss to the structure, or loss to its contents, the amount it would cost the insured to repair, rebuild, or replace the thing lost or injured less a fair and reasonable deduction for physical depreciation based upon its condition at the time of the injury or the policy limit, whichever is less. In case of a partial loss to the structure, 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. (Emphasis added)

The New ISO Form

The new ISO form tracks the statute's section (b) (1) but interprets (b) 2, as follows:

In the event of a partial loss to a building or structure, 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.

When the loss is to something other than a building or structure, actual cash value is defined as:

• 1. The amount it would cost to repair or replace the property less a fair and reasonable deduction for physical depreciation, based on the condition of the property at the time of loss; or

• 2. The Limit of insurance applicable to the property.

The form then defines "open policy" tracking statutory language as a policy where the value of the covered property is not fixed at policy inception but is determined at the time of loss.

Proposed Changes in Fair Claims Practices Regulations

ISO does not cover a proposed modification to the California Fair Claims Practices Regulations presently pending before the California Department of Insurance (CDOI). The proposed regulation would modify the methods used to determine depreciation, betterment, and salvage in property claims by refusing to allow the depreciation of the cost of labor. Since the majority of the cost of any structure or item of personal property is the labor needed to construct it, this proposal would make it impossible for an insurer to reach a fair determination of actual cash value that takes into consideration "the amount it would cost the insured to repair, rebuild, or replace the thing lost or injured less a fair and reasonable deduction for physical depreciation."

The dictionary defines depreciation as: "A decrease in value of property through wear, deterioration, or obsolescence" (Webster's New World College Dictionary, (3d ed.) and Black's Law Dictionary (7th ed.)). If the value of labor is taken from replacement cost, as contemplated by the proposed regulation, the decrease in value required to obtain a true actual cash value by deducting depreciation, would be skewed closer to replacement cost since a major component of value is eliminated from the calculation.

Form IL 01 02 05 05 attempts to avoid the problem in the California statute and proposed regulation by using language requiring a determination of physical depreciation "less a fair and reasonable deduction … of the components of the building or structure that are normally subject to repair or replacement…." In this attempt, it fails. The form limits—in a fashion similar to the proposed regulation—by limiting in the calculation of actual cash value, the taking of depreciation from replacement cost to those components of the building that are normally subject to repair or replacement "during its useful life." This will act to complicate and make almost impossible obtaining an agreed actual cash value.

The components that are normally subject to repair or replacement will clearly include the following.

1. Roofs
2. Paint
3. Carpets
4. Plumbing
5. Electrical wiring
6. Flooring

However, can an insurer be certain that any of the following components are subject to repair or replacement?

1. Framing components—Carpentry labor used to install the framing.
2. Block walls—Masonry labor used to install the walls.
3. Foundations—Masonry labor used to install the foundations.
4. Stucco—Plaster labor used to install the stucco.
5. Fixtures—Plumbing or other labor used to install the fixtures.
6. Concrete flat work—Labor to install the concrete.

All of the six items directly above usually are not subject repair or replacement, but like all other property, depreciates. The value of a wood frame wall is not limited to the lumber and nails. To create a fully framed wall, it is necessary to purchase lumber and nails and pay for the labor (and overhead) of a carpenter.

The Need for True Indemnity—Proposals To Avoid Problems

If true indemnity—the intent of first-party property insurance—is to be reached, it is necessary that the true value of the entire structure be determined. If only some parts of the structure are not subject to depreciation true indemnity will not be determined, but rather, a sum closer to replacement cost than actual cash value will result.

Insurers who wish to have true actual cash value policy that obtains true indemnity should consider the following:

To exercise this option the insurer needs to:

1. Define the term "actual cash value" to mean "fair market value."
2. Define "fair market value" as the amount a willing buyer would pay a willing seller with neither under pressure to buy or sell.
3. Define "actual cash value loss" as the difference between the fair market value of the property immediately before the loss and the fair market value of the property immediately after the loss.

To exercise this option, rather than adopt the California statute or the language in IL 01 02 05 05 the insurer needs to:

• Define "actual cash value," in a total loss, as the cost to replace the entire structure less physical depreciation calculated.
• "Physical depreciation" is defined as:

• The reduction in value of the property equal to a percentage of the life span of the structure.
• As an example, a 50-year-old dwelling with a 100-year projected lifespan:

• From replacement cost, 50 percent will be deducted for depreciation.

• As an example, a 3-year-old dwelling with a 100-year projected lifespan an amount of 3 percent would be deducted from full replacement cost.

• If possible, the lifespan of the structure should be agreed at the time of policy issuance.

The same definitions could be used with regard to personal property as well as any other type of structure.

ISO's attempt is to comply with the statute will avoid problems with the statute but will not make it easier to negotiate settlements of actual cash value claims.

Forget about Depreciation and Actual Cash Value

Insurers must train their claims personnel on how to deal with and establish the actual cash value and the replacement cost value of property. Since depreciation and the calculation of actual cash value is a politically dangerous situation, it usually results in an unhappy insured. The best solution, in my opinion, is to delete it totally. Change the policy to read that the insurer will pay the full cost of repair or replacement—whether the insured replaces or not—and charge an adequate premium for the added cost. Of course, such a provision will be a temptation to commit fraud. The insurer should have confidence in its special Fraud Investigation Unit (SIU). The SIU should be able to defeat most of the 3 to 5 percent of claims that are fraudulent or arson-for-profit schemes.

© Barry Zalma 2006