Over the years, courts have defined ACV in one of three ways:
- RC minus depreciation.
- Fair market value.
- According to the "broad evidence" rule—a judicious combination of numbers
one and two.
Option number one is the traditional insurance industry definition. And,
over the years, courts have upheld this meaning and interpretation. A Kansas
court summed it up nicely: "The definition of 'replacement cost' stated in the
policy as the 'full cost of repair or replacement (without deduction for depreciation)'
implies that replacement cost is greater than actual cash value, and that actual
cash value must mean 'full cost of repair or replacement (with deduction for
depreciation)." Option number two—"fair market value"—also seems to be a rather
straightforward method. It has always been thought of as "what a willing buyer
will pay to a willing seller."
Turning to California
In the case of Cheeks v. California Fair Plan,
61 Cal. App. 423, 71 Cal. Rptr. 2d 568 (Ct. App. 1998), the California Appellate
Court came down squarely on the side of using "fair market value" as the definition
of ACV in California. In this case, Mr. Cheeks's home sustained earthquake damage
in the Northridge earthquake of 1994. His policy with the California Fair Plan
(CalFair) agreed to pay covered losses at "actual cash value at the time of
loss, but not more than the amount required to repair or replace the property."
After determining the replacement cost of Mr. Cheeks's loss to be $563,888,
CalFair applied depreciation and the deductible, to arrive at a final ACV payment
of $44,343. Mr. Cheeks contended that the "value" of his home was considerably
more than that figure and took the insurer to court. He knew what he could get
if he were to sell the house.
Although Mr. Cheeks lost at the trial court level, he appealed. At the appeal
level, the court quoted the State Supreme Court in Jefferson
Ins. Co. v. Superior Ct. of Alameda Cty., 3 Cal. 3d 398, 90 Cal. Rptr.
608 (1970): "It is clear that the legislature did not intend the term 'actual
cash value' in the standard policy form, set forth in section 2071 of the Insurance
Code, to mean replacement cost less depreciation."
In deciding in Mr. Cheeks's favor—that ACV means "fair market value"—the
appellate court gave this advice to insurers and to those who draft insurance
policies: "If it [the insurer] wants to determine 'actual cash value' on the
basis of replacement cost less depreciation, all it has to do is say so in the
Turning to Kentucky
I consulted on a commercial property claim in 2005, where calculation of
the ACV was the central issue. The risk was a commercial building located in
Kentucky. It was insured with a standard commercial property policy for $590,000
on a replacement cost basis. After a loss, the commercial property policy gives
the insured the option of proceeding with the replacement of the building or
of taking an ACV cash settlement. Note that the option is the insured's and
that the insurer may not dictate what path he must pursue.
In February of 2004, the Kentucky building was destroyed by a fire. After
the fire, the insured obtained two estimates from local contractors who were
familiar with the building. Both of these contractors estimated that the cost
to replace the building would be around $750,000. At that point, the insured
decided not to rebuild, but to take the actual cash value settlement, as allowed
in the policy.
The policy was the standard commercial property policy, with at least one
big exception: this policy actually defined ACV as "replacement cost less a
deduction that reflects depreciation, age, condition, and obsolescence." By
including this definition of ACV in the policy, both parties to the contract—insured
and insurer—were limited to this use (and this use only) of the term.
When all calculations were finished, even after applying depreciation to
the $750,000 replacement cost, the ACV was still more than the limit of liability.
At this point, the insurer should have just proffered a check for the policy
limit and walked away. But the insurer decided to reexamine the situation. It
seems that this building was located in a deteriorating neighborhood and that,
if he had tried to sell it, the building's owner could only have gotten about
$294,000 for the building—nowhere near the limit of liability of $590,000. After
finding out about the building's rather low market value, the insurer said it
would pay no more than the estimated market value of the building, $294,000.
It was at that point that I became involved. Although I emphasized that I
am not a lawyer, my take on the situation, from more than 25 years' experience,
was that the definition of ACV in the policy bound both parties to it and that
the insurer could not just "willy-nilly" decide to revert to market value for
payment when it had already defined how it would pay. In appraisal, a settlement
was reached for just under $590,000. The umpire even chastised the insurer for
its efforts to circumvent the wording in its own policy.
An old saying goes: "Be careful of what you wish for—it might just come true."
In this case, the advice to the insurer might have been: "Be careful of how
you define a term—it may come back to haunt you."
Overhead and Profit
Another sticky point in negotiation between insured and insurer is the application
of and payment for "overhead and profit" (O & P). When calculating ACV, some
insurers start with replacement cost, then deduct depreciation, then deduct
another 20 percent for contractor's overhead and profit.
In Gilderman and Gilderman v. State Farm,
649 A.2d 941, 437 Pa. Super. 217 (Pa. Super. Ct. 1994), the Pennsylvania Superior
Court clearly said this practice was wrong. This decision was upheld in 1995
by the state supreme court's refusal to review the case. I think the important
thing to remember is that the price of anything—a new roof for a home, a car,
furniture, or clothing—includes a component for overhead and profit. If I were
to go into a car dealer or a clothing store and tell the salesperson that I
wanted to buy that car or that suit, but I would be taking 20 percent off the
price for "overhead and profit," I'd be laughed out of the store. In the Gilderman case, the Pennsylvania Court advised
insurers to be careful or they would be laughed out of town as well.
Unless otherwise dictated by statute or court decision, here is how I think
overhead and profit should be handled in a homeowners loss:
Turning to Florida
In Florida, the issue of overhead and profit and how to pay for a loss had
become so bad, so contentious, that the legislature stepped into the fray. Provision
2.d of "Loss Settlement" in the standard HO-3 homeowners policy from Insurance
Services Office, Inc. (ISO), says that the insurer will only pay ACV for a homeowners
loss "until actual repair or replacement is complete." Paragraph 2.e of the
same policy allows the insured to make an initial claim for the ACV of the loss
and then take up to 180 days to decide if he or she wants to replace the damaged
Again, because of all the problems with homeowner claims and calculation
of ACV in Florida, the Florida Legislature took away the ACV option. As of January
2006, paragraph 2.d only applies to mobile homes and paragraph 2.e has been
So what loss settlement options are now open to homeowner insurers in Florida?
Forgetting any insurance-to-value problems, insurers are now left with paragraph
2.a of the Loss Settlement provision. There, the policy agrees that it will
pay the least of the following amounts
- The limit of liability.
- The replacement cost of the damaged portion of the home.
- The amount actually spent to replace the damaged portion of the home.
And without paragraph 2.d that requires rebuilding prior to payment of the
replacement cost amount, insurers must now write a check to the homeowner for
the RC of the damaged portion—even if the insured chooses not to rebuild or
repair the home. The insurer no longer has any options. It must proffer a check
to the homeowner in the amount of the replacement cost of the damaged property,
or the limit of liability, whichever is less.
Although there are many complicated issues surrounding homeowners insurance
in Florida, I'm convinced that the insurance industry could have avoided the
legislature's rather drastic measures in 2006. How? By including a definition
of ACV in the homeowners policy.