Your company has just suffered a significant loss at a key property. But management doesn't want to rebuild as it was before the incident. How will this affect your property damage and business interruption claim? And how can you balance the need to achieve management's goals while still maximizing insurance recovery?
After the initial chaos, confusion, and massive disruption typical of a catastrophic loss, a company is faced with a myriad of decisions. Most of them ultimately focus on the same issue: How can we mitigate the loss and resume operations as quickly as possible? A major part of this process typically includes repairing or rebuilding the damaged facility.
The basic intent of property damage and business interruption coverage is to repair or replace damaged property and to reimburse the insured for lost profits and continuing costs. However, the insured may find that it doesn't want to—or can't—repair or replace the property "as was." Some reasons may include:
Building codes have changed since original construction.
It is impractical or inefficient to rebuild the previous design.
Operations can be enhanced—changed, expanded, or minimized—by making significant changes.
The damaged location can more effectively be consolidated into or moved to another location.
The basic property insurance policy allows the insured to be reimbursed for costs to repair or replace the damaged assets and the business interruption impact for the time required to repair or replace "with due diligence and dispatch." Typical policy wording is as follows:
Property Damage In the event of such damage or destruction, the Company shall pay the actual expenditure incurred in repairing or replacing the damaged property. The term "replacement cost" as used here means the cost to repair or replace lost or damaged property with property of comparable value and quality on the same or another site, and used for the same purpose, without deduction for depreciation, deterioration, or obsolescence.
Business Interruption In the event of such damage or destruction, the Company shall be liable for the actual loss sustained by the Insured resulting directly from such interruption of business, but not exceeding the reduction in Gross Earnings … less charges and expenses which do not necessarily continue during the interruption of the business, for only such length of time as would be required with the exercise of due diligence and dispatch to rebuild, repair, or replace such part of the property as has been damaged or destroyed.
Property Damage and Business Interruption Illustrations
Let's look at a hypothetical situation. Tylake Corporation owns a manufacturing plant located in Des Moines, Iowa, that produces dizaphones. The plant suffers a fire that destroys the entire plant.
Scenario 1: Rebuild the Property as It Was before the Incident
Tylake rebuilds the plant as it was before the incident a cost of $1 million. The time to complete repairs is 6 months. What is Tylake entitled to under its property policy?
Tylake is entitled to the $1 million that it incurred to complete repairs. It is also entitled to the business interruption losses incurred during that 6-month period of time.
Scenario 2: Rebuild "As Was," but Comply with "Code Upgrades"
Although Tylake's management is willing to replace the plant as it was before the incident, new building codes written after original construction must now be adhered to, for an additional cost of $200,000. What is Tylake entitled to?
The insured's policy will dictate the amount of coverage that is provided. While the standard ISO CP 00 10 "Building and Personal Property Coverage Form" provides coverage for the increased costs incurred to comply with the enforcement of new building codes, it also places a cap on the amount of such coverage. Many companies craft customized (manuscript) policies which either expand or do not limit the amount of such coverage. Typical wording for this type of policy is as follows:
Increased Cost of Construction
In the event of physical loss or damage covered hereunder that causes the enforcement of any law or ordinance in effect at the time of loss regulating the construction, repair or use of property … this Company will be liable for the increased cost of construction.
With this type of coverage, most policies typically require that the code upgrade be in place before the incident occurred. For example, after some of the recent hurricanes, local authorities made changes to code requirements after the incident. Costs incurred to meet such code upgrades may not be recoverable.
Assuming that Tylake's policy had code upgrade wording such as that shown above, and that the new building codes were written prior to the incident, Tylake should be entitled to recovery of the total cost incurred, including the costs incurred to meet the new codes, or $1,200,000.
Scenario 3: Comply with "Code Upgrades" that Extend the Time To Complete Repairs
When code upgrades are required, it often means that the time to complete the repairs is longer. Tylake is happy to hear that the cost of the code upgrades will be reimbursed under its property policy. But it also finds that the time to rebuild the plant will take longer in order to adhere to the code upgrades. Instead of completing the repairs in 6 months, it will take 8 months to complete the repairs and meet the new code requirements. What is Tylake entitled to?
The standard ISO CP 00 30 "Business Income (and Extra Expense) Coverage Form" states that ""period of restoration" does not include any increased period due to the enforcement of any ordinance or law that regulates the construction, use or repair, or requires the tearing down of any property." For this reason, most companies that have manuscript policies which cover the increased costs of construction due to code upgrades (as discussed in Scenario 2 above) typically also have manuscript policies that provide for the period of interruption to reflect the increased time to adhere to the code upgrades. Typical wording is as follows:
Increased Cost of Construction
This policy also covers any increase in the Business Interruption and extra expense loss arising out of the additional time required to comply with state law or ordinance.
If Tylake's policy has code upgrade wording similar to the above, the additional time required to comply with the code upgrades should be covered.
Scenario 4: Don't Rebuild
Tylake decides not to rebuild the damaged plant at all. What is Tylake entitled to?
Most policies state that the insured must take a reduction for depreciation if they decide not to rebuild and to "cash out" on the policy. Typical wording is as follows:
Actual Cash Value
If within one year, the process of repairing, rebuilding, or replacing the property has not begun, then the value of the property will be the Actual Cash Value. The term "Actual Cash Value" as used here means the Replacement Cost with deduction for depreciation, deterioration, or obsolescence.
If the insured's policy includes wording similar to that above, and it decides not to complete the repairs, it would be entitled to the $1 million, less a factor to reflect the physical deterioration or depreciation of the property.1
When the repairs are not made, the insured is typically entitled to business interruption losses incurred for the estimated time that it would have taken if repairs were indeed made.2
Scenario 5: Make Significant Enhancements
Tylake decides to make significant enhancements to the plant rather than to rebuild it as it was before the incident. Instead of repairing the plant for $1 million, it intends to spend $2 million to enhance the facility. The time to complete repairs is expected to take 9 months rather than the 6 months that was expected if the facility was repaired as it was. What is Tylake entitled to?
When a significant loss occurs, the insured should determine if repairing the damaged asset as it was before the incident makes good business sense—from an operational and financial perspective. In this scenario, Tylake should be entitled to the $1 million cost to rebuild the plant as it was before the incident and should be entitled to business interruption losses for the 6 months that that it would have taken to rebuild the facility to as it was before the incident.
When a significant property loss occurs, the insured should carefully review all options regarding repair or replacement of the damaged facility. Should the facility be repaired or rebuilt? Should it be relocated to a different location? Should significant changes be made to the facility?
The insured should also carefully review its insurance policy to determine what may be recoverable by insurance under each option. It is important to recognize that the amounts recoverable under its property and the business interruption policies may not be based not on the actual costs incurred—or the actual time to complete the repairs—but rather on estimates of what it would have taken to repair the asset as it was before the incident.
A thorough analysis of all the facts and various options, utilizing the services of qualified forensic accountants, insurance professionals, and attorneys can help point the way to an effective course of action and a beneficial recovery.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
1 The amount taken for depreciation is typically an estimate based upon the age and remaining useful life of the property. It does not represent the accounting depreciation taken on the books of the insured. Typically, the amount of depreciation taken is no more than 50 percent. Also, most policies do not provide for any recovery for code upgrades if the cost is not actually incurred.
2 Additional debate may occur if the policy provides for coverage for an "Extended Period of Indemnity" but the damaged asset is not repaired. Many policies specify that losses incurred during an extended period of indemnity only apply when repairs are actually made.