Depreciating the cost of new materials is widely accepted and is not subject to dispute. But when it comes to labor, it is a different matter.

Two similar cases reached the Oklahoma Supreme Court and were answered within a day of each other in 2002. Both cases involved damage to roofs and an actual-cash-value settlement. Both also addressed depreciation of labor.

In the first, Redcorn v. State Farm, the court said, “A roof is the product of both materials and labor,” and so depreciation of labor costs was allowable. But in a dissenting opinion, three justices argued that labor costs should not be depreciated. A roof, they stated, is not a single product consisting of labor and shingles, but rather is a combination of products (shingles and nails) and a service (labor to install). Labor, they argued, cannot lose value over time.

One dissenting justice also pointed out that prior to the loss, the insured had an installed, 16-year old roof. To be indemnified meant the policyholder was entitled to the value of the 16-year-old shingles plus the cost of installing them.

The second case before the same court, Branch v. Farmers Insurance, also dealt with depreciation of labor. In this instance, the court was asked to determine if the labor costs for tearing off a damaged roof could be depreciated or whether this cost should be covered under debris removal. In its answer to the first question, the court said that labor to install the new roof was a cost the insured was reasonably likely to incur, which meant it was rightly included within the meaning of replacement cost. It followed, then, that labor could be depreciated along with materials.

But having said that, the court noted that most homeowners' policies contained a separate coverage for debris removal following a covered loss. If a roof was damaged to the extent that it had to be replaced, then the damaged portion was debris. Furthermore, if the whole roof had to be torn off in order to repair or replace the damaged portion, the torn-off pieces also must be considered rubble. Therefore, although the cost of the labor to replace the roof could be depreciated, the cost to remove the debris of the old roof could not.

Overhead, Profit Depreciation

Another frequently asked question is, “Should contractors' overhead and profit be depreciated?” The Pennsylvania Superior Court addressed this in Gilderman v. State Farm in 1994. Here, the issue was whether the insurer could automatically deduct 20 percent of a contractor's overhead and profit in addition to depreciation in order to reach actual cash value.

The insureds argued that contractor overhead and profit should be included in figuring replacement costs; the insurer argued that it should not since a contractor was not always used. The insurer held that the insured would reap a windfall profit if overhead and profit were included in calculating replacement. The court noted, though, that insureds under a replacement-cost policy had paid additional premium dollars for the coverage and would lose the benefit of that coverage if they did not elect to repair or replace, which meant that they could not be held to have gained. Overhead and profit was a component of replacement cost and could be depreciated, but an additional amount should not be withheld.

The Supreme Appellate Court of New York addressed the same issue in Mazzocki v. State Farm Fire & Casualty. In a 2003 verdict, the court held that the insurer was obligated to include profit and overhead in replacement cost and, therefore, in actual cash value whenever it was reasonably likely that the services of a contractor would be needed. The court looked to Gilderman and to a Michigan case decided by the appellate court, Salesin v. State Farm Fire & Casualty.

Role of Broad-Evidence Rule

Many states adhere to the broad-evidence rule in reaching actual cash value. Under this rule, as the court explained in the New York case of Mazzocki, “Every fact and circumstance that would logically tend to the formation of a correct estimate of the loss” could be considered. The Supreme Court of Nebraska held in 2005 that if a policy contained no definition of actual cash value, then market value — the amount that a willing buyer might pay a willing seller — could be used, as well as any other facts that established value. (See Olson v. Le Mars Mutual Insurance Co. of Iowa.)

Many states, having seen the resulting confusion, are requiring that a definition be added to policies. Nebraska, doubtless as a result of Olson, now states in its homeowners' special provisions that, “In our determination of the actual cash value of covered property at the time of loss, an adjustment will be made for factors such as depreciation, deterioration, and/or obsolescence.”

The state of Washington has a comprehensive definition that encompasses whether a loss is repairable or whether the property has sustained a total loss. Maine, in an attempt to clarify, might possibly have opened up another can of worms with its definition: ” 'Actual cash value' means the replacement cost of covered property at the time of loss, less the value of physical depreciation as to the damaged property. 'Physical depreciation' means a value as determined according to standard business practices.”

Standard? According to which business? Enron? And so it continues ….

Diane W. Richardson, CPCU, is an associate editor with Fire, Casualty, & Surety. She is the author of several books on the subject of homeowners' insurance and has a background in insurance underwriting. She may be reached at [email protected]. The FC&S Claim Queue is prepared and written by the editorial staff of The Fire, Casualty and Surety (FC&S) Bulletins, the most widely used encyclopedic reference service devoted to insurance policy interpretation and coverage topics. FC&S is published by The National Underwriter Company. The editors welcome comment at [email protected].