An important question to ponder

"Three trade rule" and "reasonably likely" standard

A confusing subject to many

 Introduction

Mention of the words "overhead and profit" with reference to property insurance loss adjusting usually conjures up the questions of under what circumstances are both overhead and profit covered, and for what amount? The reason for these questions is that property policies are silent on the payment of overhead and profit, and some insurers are not overly receptive to paying for them in every instance. Some insurers will reluctantly pay, particularly when confronted with a class action suit and usually then only for those charges actually incurred, or reasonably likely to be incurred. From the perspective of some insurers, overhead—which deals with general expenses not chargeable to any specific job, such as utilities, office equipment and office payroll—is sometimes difficult to determine.

Some insurers feel that overhead and profit should be deducted from actual cash value (ACV) adjustments of loss, even though it is only use, obsolescence, or depreciation that is commonly deducted from replacement cost. For insurers to be required to pay some portion of contractors' overhead and profit when insureds are free to accept the ACV amount as the final settlement without further obligation to repair or rebuild the covered property is viewed by some insurers as unjust enrichment or windfall. In other words, some insurers maintain that it is not until the property is rebuilt or reconstructed that overhead and profit needs to be paid and, even then, some insurers will require proof that such expenses are to be reasonably incurred.

For example, Hurricane Katrina destroyed a home, which was insured against flooding under the National Flood Insurance Program (NFIP). Because of a disagreement between the parties, in Dwyer v. Fidelity National Prop. and Cas. Ins. Co., 428 Fed. Appx. 270 (U.S. Ct. App. 5th Cir. 2011), both the named insured and insurer moved for an appointment of an umpire. The umpire submitted to the district court, an appraisal, which consisted of the amount of damage to the home and a mark-up for overhead and profit. The insurer accepted the umpire's damage figure, which was approximately $1,500 more than its original estimate, but the insurer contested the addition of overhead and profit. Its reason was that overhead and profit is a "pass-through cost" intended to reimburse homeowners for the expense of using a general contractor. Since the named insureds sold their home unrepaired, they were said to have never incurred, and will never incur, the cost of a general contractor and, therefore, were not entitled to overhead and profit.

It would appear, therefore, at least based on the foregoing case, that for a named insured to obtain a loss settlement that contains costs of overhead and profit (and taxes that go into the purchase of materials) three conditions precedent must be met by the named insured: (1) must complete the repairs or replacement of the damaged property; (2) must actually incur the overhead, profit, and sales tax in connection with the repairs or replacement; and (3) must make a further claim for additional costs (including overhead, profit, and taxes) incurred in actually repairing or replacing the property in question.

 The Fallacy of the Insurers' Position

The fallacy of the foregoing case and those arguments of insurers maintaining that overhead and profit should be deducted from actual cash value of covered property is that ACV already includes overhead and profit. This can be explained by looking at the definition of actual cash value. It is commonly defined as replacement cost less usage (or commonly referred to as depreciation). Since replacement cost includes overhead and profit, both should also be included in actual cash value. At the time actual cash value is paid to the insured, a portion of the overhead and profit should also be paid and the remainder of both paid when the property has been fully repaired or replaced. For an insurer to instead want to deduct overhead and profit from actual cash value and agree to include them after the property has been repaired or replaced may be considered double-dipping, meaning it is not proper to do so.

One can understand that when damaged property is repaired or replaced, part of the costs to be incurred (and therefore covered by insurance) will be overhead and profit of the contractor(s) and any taxes having to do with the purchase of required materials and equipment. When losses are over a certain amount, and depending on the policy, named insureds have one of two options:

1. Accept the money equivalent of the actual cash value of the covered property—the cost to replace or repair property with new materials of like kind and quality, less an allowance for usage. In this case, the named insured is under no obligation to repair or rebuild and, instead, is free to use the settlement for anything.
2. Make the necessary repairs and later make a claim with the insurer for the additional amount incurred to repair or replace the property, including the remaining portion of costs of overhead, profit, and taxes. The named insured must notify the insurer within 180 days if the intent is to repair or replace the covered property. Failure to notify the insurer within the permitted time may nullify this feature of the policy.

 An Important Question to Ponder

If an actual cash value settlement includes contractors' overhead and profit and the named insured decides not to repair or replace the covered property or to make the necessary repairs without the assistance of a contractor, an important question is whether there is an overpayment representing a contractor's overhead and profit.

Some insurers view this kind of situation as an overpayment and deduct overhead and profit from an ACV settlement, even though property policies generally state that actual cash value means replacement cost new less depreciation, obsolescence, or usage. One such case on this point is Ghoman v. New Hampshire Ins. Co., 159 F. Supp.2d 928 (N.D. Tex. 2001). The named insured, an owner of a hotel, obtained a property policy for a limit of $6 million, covering against all risks of direct physical loss. While the policy was in effect, the hotel was badly damaged by wind and hail. AIG, acting on behalf of the insurer, offered $15,000 to settle the claim. The named insured rejected this offer and, instead, demanded an appraisal, which valued the replacement cost at $299,907 and the actual cash value at $262,353. In response to this, the insurer tendered payment in the amount of $190,414. This sum represented the cost of replacement as determined by the umpire, less depreciation, contractor's overhead and profit, sales tax on building materials and a $1,000 deductible. The named insured, however, contended that with exception of depreciation and the deductible, all the other sums withheld by the insurer were recoverable under the policy. In light of this disagreement, the named insured brought a class action suit against the insurer.

The sum of $190,414 tendered by the insurer in full satisfaction of the claim represented the replacement cost of $299,907, less $37,554 in depreciation, $48,083 in contractor's overhead and profit, $22,856 in sales tax, a $1,000 deductible. The named insured sought the actual cash value of the loss, or $262,353, which was the replacement cost less depreciation. The insurer, on the other hand, argued that the named insured could not obtain any further payments because he made a replacement cost claim and spent only $139,608.78. The policy, however, was said to give the named insured the option to either make a claim for replacement cost or actual cash value supplemented by additional replacement cost coverage. By this lawsuit, the named insured sought $48,083 in contractor's overhead and profit and $22,856 in sales tax, which was asserted to be wrongfully deducted from the ACV claim.

By using excess and surplus materials and having some of the repairs done by on-site maintenance personnel, the named insured spent only $139,609 to repair the property. The insurer, therefore, maintained that since it had already paid $190,414, or $50,805 more than the actual cost of repairs, no further payments were owed.

In referring to the policy provisions, the court stated that an insured cannot recover repair or replacement costs unless and until the insured actually repairs or replaces the insured structure. The court also stated that the insured cannot recover repair or replacement costs in excess of what has actually been spent on repair or replacement costs. However, the court went on to say, these well-settled principles of insurance law are only applicable where the insured seeks replacement costs and such was not the case here. The evidence conclusively established, the court added, that the named insured filed a claim for actual cash value of the loss, supplemented by additional replacement cost (following repairs), rather than a replacement cost claim.

In the final analysis of this case, the court found by withholding $48,083 in contractor's overhead and profit and $22,856 in sales tax from the named insured's ACV award, the insurer breached its obligations under the policy. The insurer's motion for partial summary judgment, with respect to the bad faith count, was denied.

Another case is Tritschler v. Allstate Ins. Co., 144 P.3d 519 (Ct. App. Ariz. 2006), which involved a dispute when the named insured on a homeowners policy sustained a loss and hired a contractor to perform the work. Because of the named insured's dissatisfaction with the work performed, the named insured finished the repairs and submitted a claim. The insurer offered a cash out settlement that represented the difference between what was paid to the contractor and its estimated cost, less overhead and profit charges included in the estimate. The insurer's offer also stated that if the named insured decided to use a general contractor, the insurer would reimburse the named insured for the contractor's overhead and profit. Litigation ensued. The insurer argued, and the trial court agreed, that because the policy limited the named insured's reimbursement to "the amount actually and necessarily spent" to repair or replace the damaged property, the named insured was not entitled to a reimbursement for those amounts.

Because the named insured was entitled to the actual cash value of the damage, the question on appeal was whether the term "actual cash value" in the homeowners policy included general contractor overhead and profit when no contractor is used. Not finding any court case in Arizona directly addressing this issue, the court sought out cases in other jurisdictions.

One case that supported the insurer's position is Snellen v. State Farm Fire & Cas. Co., 675 F. Supp. 1064 (W.D. Ky. 1987). The court considered whether an insured who elects not to repair the property and to, instead, accept the actual cash value, is still entitled to payment of contractor's overhead and profit.

The district court held that since the goal is to arrive at the actual cash value of the damage, nondamage factors, which are applicable only in the instance of repair or replacement, such as clean-up, profit, overhead, and permits were to be properly deducted.

In Gilderman v. State Farm Ins. Co., 649 A.2d 941 (Pa. Super. Ct. 1994), the policy made the unusual offer of providing an ACV cash-out or payment for the cost to repair or replace the covered property within a certain period. On a cash-out basis, the policy limited recovery to the amount actually incurred in repairing or replacing the damaged property. The Pennsylvania appellate court here had to consider whether the insurer could deduct contractor's overhead and profit from its repair or replacement estimate and to offer the named insured an advance check for this lower amount as a payment of ACV. In its analysis, the court acknowledged that certain types of property damage may be relatively minor and not require a general contractor to manage the repairs and that, in such cases, "contractor expenses would not have to be included in repair or replacement estimates. This court, however, also noted that "there are types of property damage where a homeowner would use the services of a general contractor . . . especially where there is extensive damage to a home requiring the use of more than one trade specialist." This court found that, in these instances, an insurer may not deduct contractor fees from the actual cash value when such fees are reasonably expected to occur. The court also extended this rationale to instances when the insured might not actually incur labor costs, i.e., when the insured makes his own repairs to a covered loss. Thus, in contrast to the foregoing Snellen case, the court in this Gilderman case found the insurer's automatic deduction of contractor's fees to be improper, holding that "repair or replacement costs include any cost that an insured is reasonably likely to incur in repairing or replacing a covered loss, even if the insured may never make the repairs.

In Salesin v. State Farm Fire & Cas. Co., 581 N.W.2d 781 (Mich. Ct. App. 1998), the named insured had the option to select replacement cost coverage but, instead, elected to recover damages for a loss pursuant to an actual cash value option. The Michigan appellate court considered the propriety of the insurer's routine practice of deducting contractor's overhead and profit fees from the actual cash value it paid its insureds. After considering the rulings in the foregoing Snellen and Gilderman cases, the court found the reasoning in Gilderman to be more persuasive. The Michigan court reasoned that, because ACV is an estimate of all costs that will likely and reasonably be incurred in repairing or replacing the damaged property, the expense of a general contractor cannot be deducted from this estimate unless such services are not likely to be required. The court further noted that the insured having made his own repairs and not actually incurring any contractor fees did not affect its holding. Relying on the Gilderman case, the Salesin court upheld the trial court's ruling that the insurer's practice of automatically deducting contractor overhead and profit from the actual cash value payment was improper.

A number of other jurisdictions have also ruled that an insurer cannot automatically deduct a contractor's overhead and profit from an ACV payment, including Mazzocki v. State Farm Fire & Cas. Co., 766 N.Y.S. 2d 719 (App. Div. 2003), where the court held that an insurer "was obligated to include profit and overhead in. . . actual cash value, whenever a general contractor would likely be needed." Other courts that have followed this reasoning are Bankers Sec. Ins. Co. v. Brady, 765 So.2d 870 (Fla. Dist. Ct. App. 2000) and Weidman v. Erie Ins. Group, 745 N.E.2d 292 (Ind. Ct. App. 2001).

Returning to the Tritschler case, the insurer argued that as a public policy consideration, such a result in permitting the insured to collect contractor's overhead and profit fees in an ACV selection would overcompensate insureds who choose to repair their own properties and would not only generate a windfall for insureds, but also violate the principles of indemnity. The court was quick to respond, however, that the insurer agreed to pay the named insured the actual cash value of the damaged property and to accept premiums based on that agreement. The actual cash value is an estimate of needed repairs, the court explained. The determination of actual cash value, the court went on to say, is based on what the insured actually pays to repair or replace the damaged property. Therefore, the court added, the amount an insured ultimately spends to make needed repairs, if any, is "irrelevant."

The court also said that regardless of whether an insured hires a general contractor or completes his own repairs, the insured would still be entitled to what was contracted for in the insurance policy: the actual cash value of the loss, which may include contractor's overhead and profit when a contractor may reasonably be used to make repairs. The court also said that it could not be concluded that requiring an insurer to satisfy its obligations under an insurance policy would violate the principles of indemnity.

The court concluded that, (1) actual cash value in adjusting a property loss includes any cost that an insured would be reasonably likely to incur in repairing or replacing a covered loss, regardless of whether the insured intends to repair or replace the covered property; and, (2) if the cost to repair or replace the damaged property would likely require the services of a general contractor, the contractor's overhead and profit should be included in determining the actual cash value, even when an insured elects to complete the repairs personally.

One other case worth mentioning, which involved an insurer of mobile homes, is Mills v. Foremost Ins. Co., 511 F.3d 1300 (11th Cir. 2008). The insured alleged that the insurer failed to pay the named insured for contractors' overhead and profit charges, along with state and local sales taxes on materials that had to be purchased in the repair work. The district held that for the named insured to have been eligible to collect the withheld payments of overhead, profit, and taxes, the named insured would have had to satisfy the preconditions of the policy:

(1) complete the repairs or replacement of the damaged property;

(2) actually incur overhead, profit, and sales tax in connection with the repairs or replacement; and

(3) make further claim for any additional costs (including overhead, profit, and sales tax) incurred in repairing or replacing the damaged property.

The mobile home policy stated that if the loss were less than $2,500, the named insured would receive a replacement cost adjustment, i.e., without a deduction for depreciation. When the loss is for a higher amount, which was the case here, the policy paid no more than ACV until the repair or replacement was completed. If the ACV method were chosen, the named insured had 180 days after the loss to make further claim for additional costs incurred in repairing or replacing the damaged property. However, having to make actual repairs first was not required in order to be paid the actual cash value of the loss.

On appeal, the court stated that the mobile home policy defined actual cash value as "the cost to repair or replace property with new materials of like kind or quality less certain depreciation." The policy did not say, the court added, repair or replacement cost less depreciation and profit, overhead, and taxes and, therefore, these costs were not ambiguously excluded from actual cash value coverage. As to taxes, the court stated it could easily conclude that "the cost to repair or replace property with new materials" would necessarily include the state and local taxes on the materials purchased to make the repairs. Part of the cost of new materials is the taxes paid to purchase those materials.

As to the cost of installing materials, the insurer did not dispute that general contractors routinely charge overhead and profit for their services, but argued that, (1) not all hurricane repairs would necessarily require the services of a general contractor; and, (2) the named insureds did not specifically plead that they needed a general contractor to repair their mobile home.

In reply, the named insureds pointed out that a contractor's overhead and profit are routinely as much a part of the cost to repair as is the contractor's labor and materials costs. The insureds' complaint specifically alleged that the insurer failed to pay them overhead, profit, and taxes incurred by them in repairing their mobile home. The insureds also asserted that there was no support for the insurer's exclusion of contractor's overhead and profit charges in the policy's broad language of "cost to repair or replace property."

The court of appeals stated that for several reasons it agreed that contractor's overhead and profit charges were included in the "cost to repair or replace" terminology of the policy. The policy definition of actual cash value did not exclude overhead and profit charged by contractors in their repairs or replacements, or otherwise limit the type of repair or replacement costs covered by the policy. Since contractor's overhead and profit charges are well-recognized types of costs routinely charged, the appeals court said, those items fell within the cost to repair or replace. Additionally, the named insureds contracted for the actual cash value of their loss and their recovery was not tied to actually making the repair or replacement, much less actually paying a contractor anything. The issue of what was encompassed within the policy language of "cost to repair or replace" was deemed a separate and distinct issue from whether certain items of repair costs were reasonable and necessary. The court also said that its decision comported with the weight of authority on this issue.

The minority view concerning contractor's overhead and payroll is that to obtain coverage for those costs, the insured must first complete the repairs or replacement of damaged property, and actually incur contractor's overhead, profit, and sales tax in connection with the repairs or replacement, before the insured can make a claim for those additional costs. The majority view, on the other hand, appears to be that contractors' overhead and profit are part of an actual cash value settlement because the only item deducted in determining actual cash value is depreciation or usage. The view here is that the insurer's automatic deduction of contractor overhead and profit is improper because repair or replacement costs include any cost an insured is "reasonably likely" to incur, even in those cases where the insured may never make the repairs.

 "Three Trade Rule" and "Reasonably Likely" Standard

Whether contractors' overhead and profit are included in the actual cash value amount—even when insureds decide not to repair or rebuild or are paid separately after the named insured makes the repairs or replacement of damaged covered property and incurs those expenses—leads to an important question: how are those charges calculated? It appears that deciding what factors to use is purely guesswork.

One of the rules espoused by insureds as being a determinate in establishing the amount of overhead and profit—which appears to be growing in popularity—is the so-called "three trade rule." In general, this rule states that when three trades are likely to be required to repair the damaged property, a general contractor is presumed to be required to coordinate, supervise, and oversee the repairs and, therefore, a 20 percent contractor's overhead and profit payment should be included in the ACV settlement. Many of the cases that have advocated the "the three trade rule" also involved class actions where the courts, for the most part, did not make any decisions about the rule's application but merely discussed it. One such case is Burgess v. Farmers Ins. Co.., 151 P.3d 92 (Sup. Ct. Okla. 2006).

The plaintiffs who were named insureds under homeowners policies sought class certification against the insurer for alleged systematic underpayment of property damage claims for amounts attributable to general contractor's overhead and profit and failure to disclose to the insureds their potential entitlement to this benefit at the time of the insurer's actual cash value settlement. At the heart of this controversy was the insureds' allegation that there is an industry standard "three trade rule," which dictates that upon a determination that three trades are implicated in the repair of property, a general contractor is presumed to be needed to coordinate, supervise, and oversee the repair and, thus, a 20 percent overhead and profit payment is included in the calculation of the ACV settlement. The insurer denied the existence of such rule and argued that if this rule applied, it would result in the expansion of the insurer's contractual obligations. Thus, the insurer claimed it was a case-by-case determination whether to include the 20 percent overhead and profit payment at the time of the ACV settlement of the claim. The trial court examined the rule but, unfortunately, did not make any decision on it. The court examined the "three trade rule" solely for purposes of identifying the class (class members included only those claimants with claim files reflecting that the involvement of three or more trades was anticipated in the property repair at the time of the ACV adjustment).

Sometimes when insurers are confronted with class actions over overhead and profit, some will agree to pay overhead and profit with an actual cash value payment but only if it is "reasonably likely" that contractor services will be used. A number of cases mentioned earlier have applied this rule. Another "three trade rule" case that discussed the "reasonably likely" standard is Lindquist v. Farmers Ins. Co. of AZ, 2008 WL 343299, No. CV 06-597-TUC-FRZ (U.S. Dist. Ct. D. Ariz. Feb. 6, 2008).

Due to a water leak in the plumbing system, the named insured's house was damaged. When the named insured submitted an ACV claim for the damage, the insurer subtracted an amount for depreciation and deductible. The insurer also refused to pay any amount due for general contractor overhead, profit, and taxes (collectively OP&T). The insurer's refusal was said to be in compliance with its policy of not paying for OP&T unless and until these costs were incurred by its insureds. This policy, however, was in breach of the terms of the insurer's policies, which required payment of actual cash value that, in repairs involving three or more trades, includes OP&T. The named insured also alleged that the insurer's "implementation of a company-wide policy, which it knew to be based on incorrect, unreasonable, and bad faith interpretation of the relevant coverage provision in its insurance policy, led to a systematic practice of attempting to undervalue claims, and systematic practice of attempting to settle claims for less than the amount to which its insureds are entitled."

In arguing that a "reasonably likely" standard applied in this case, the insurer referred to the Tritschler case, discussed earlier. In that case, the court held that "actual cash value in adjusting a property loss includes any cost that an insured would be reasonably likely to incur in repairing or replacing a covered loss, regardless of whether the insured intended to repair or replace the property. And if the cost to repair or replace the damaged property would likely require the services of a general contractor, the contractor's overhead and profit fees should be included in determining actual cash value, even when an insured ultimately elected to personally complete the needed repairs."

Interestingly, the court noted that throughout the insurer's briefs, it referred not to "likely require" but, instead, to a "reasonably likely" standard to support its arguments for dismissal of the class allegations. Since Tritschler, said the court, specifically used the term "likely require" as applied to an insurer's duty to pay for general contractor's overhead and profit, the court would use the same standard applicable in this case since that was simply the language used in the Tritschler case.

Another case that sought class action status that is more informative about the "three trade rule" and the "reasonably likely" standard (even though the case was remanded for further proceedings) is Mee v. Safeco Ins. Co., 908 A.2d 344 (Sup.Ct. Pa. 2006). The named insured sustained direct physical loss to his home as a result of an overflowing toilet. After the named insured reported the loss promptly, the insurer sent a general contractor to inspect the damage and provide a repair and replacement cost estimate. The general contractor submitted an estimate of $3,892, which did not include a line-item cost for overhead and profit. The insurer also hired Comsearch to conduct an adjuster's summary of the general contractor's estimate. This summary concluded that the cost of repair was $3,368, a difference of approximately $523 from the general contractor's estimate. A handwritten notation on a copy of a cover letter accompanying the insurer's payment to the named insured suggested that this amount represented a deductible for overhead and profit. The named insured, in turn, hired a public adjuster to inspect the damage and to provide a repair and replacement estimate, which came to $7,112 with the difference largely representing the cost to repair the hardwood floors.

Ultimately, the insurer issued a check in the amount of $2,284, which represented the cost of repairs less the $500 deductible and 20 percent for contractor's overhead and profit. The court stated that it was unable to reconcile the amount paid by the insurer with either of the estimates, less overhead and profit and the deductible, and was also troubled by the possibility that the insurer withheld overhead and profit, which, the insurer admitted, was not included in the original estimates, thereby reducing the insurance proceeds paid to the named insured.

The named insured accepted the check as partial settlement. Later, the named insured informed the insurer of a claim for the 20 percent representing contractor's overhead and profit. The insurer responded with a letter offering to pay overhead and profit on the flooring issue but also requested the name of the contractor who would be doing the repairs. The named insured did not respond to this request and, instead, filed a suit against the insurer alleging breach of contract, insurance bad faith, and violation of the Unfair Trade Practices and Consumer Protection Law. The trial court granted summary judgment to the insurer that it did not have to pay overhead and profit to the named insured because he did not use a general contractor to repair the damage. An appeal followed.

On appeal, the named insured asked the court to review the following questions:

1. Did the trial court commit error when it granted summary judgment in favor of the insurer, even though the record contained expert custom and usage evidence that whenever more than one trade is "reasonably required" to make repairs, a general contractor's services (with contractor's overhead and profit) are reasonably required?
2. Does the insurer's homeowners insurance policy, together with relevant custom and usage, require that the insurer automatically and unconditionally pay, to a property damage claimant, general contractor's overhead and profit whenever more than one construction trade is reasonably required to make the repairs or restoration?"

The court said that the main thrust of the dispute was over the conflicting interpretations of this court's earlier decision in Gilderman v. State Farm Ins. Co., 649 A.2d 941 ( Pa. Super. 1994). While it is somewhat complicated to compare and contrast the decisions, this one is particularly complex because the Pennsylvania case misapplied the case of Gilderman, which is referred to herein weighing the argument of the later Mee case. It is nonetheless worth going through this exercise, in light of the issues and principles advocated by the court's justice.

Briefly, the court held in Mee that where repair or replacement costs are "reasonably likely" to be incurred, the insurers are not permitted to deduct overhead and profit, even when the named insured performs the work. The insurer, on the other hand, interpreted Gilderman as imposing a requirement that an insurer look at the facts of each case in making its determination of whether use of a general contractor was "reasonably likely." Because the named insured in Mee did not hire a general contractor but performed the work himself, the insurer argued that use of a general contractor was not "reasonably likely" and, therefore, the named insured was not entitled to overhead and profit.

According to the court, both the Gilderman and Mee cases missed the mark. The court held that the issue in Gilderman was whether an insurer, which had agreed to pay repair or replacement costs less depreciation in advance of actual repair or replacement of a covered loss, may automatically withhold both depreciation and a flat 20 percent representing contractor overhead and profit from its advance payment. Tailoring the Gilderman issue to fit the Mee case, the question became whether an insurer, that agreed to pay actual cash value in advance of the repair or replacement of a covered loss, is required to include 20 percent for overhead and profit in its advance payment where no general contractor was used because the homeowner did the work. According to the court, the answer depended on whether use of a general contractor was "reasonably likely" and that was a question of fact for the jury to decide.

Like the Mee case, Gilderman involved a policy that provided coverage for replacement cost. The homeowner in Gilderman argued that "contractor overhead and profit must always be included in repair or replacement costs estimates [because repair or replacement costs necessarily include overhead and profit]." State Farm countered that "contractor overhead and profit never has to be included in repair or replacement cost estimates, since contractors are not always used to repair or replace damaged property."

Before addressing the parties' arguments, the judge made the following initial observation: "Repair and replacement costs logically and necessarily include any costs an insured reasonably would be expected to incur in repairing or replacing the covered loss." Turning to the homeowner's claim that repair or replacement cost estimates necessarily include 20 percent for a general contractor's overhead and profit, the judge opined:

We believe that there clearly are certain types of property damage claims which will not require the services of a general contractor. An example is where a loss involves only a damaged pipe, and a plumber alone would normally be called to perform all necessary repairs. In this respect, we therefore agree with State Farm's position that there are some types of covered losses where the services of a general contractor normally would not be utilized. Thus, in some cases, contractor expenses would not have to be included in repair or replacement cost estimates.

Indeed, [Gildermans] implicitly concede that general contractors are not always needed, noting that it is generally accepted in the building trade that if more than three trade categories of subcontractors are involved in the repairs, the owner is entitled to the services of a general contractor to obtain bids, hire subcontractors and coordinate/supervise the work.

On the other hand, however, there are types of property damage where the homeowner would use the services of a general contractor. There are many instances where the insured reasonably would be expected to call a contractor, especially where there is extensive damage to a home requiring the use of more than one trade specialist. Thus, State Farm may not make repair or replacement estimates, then deduct 20% representing contractor's fees, when those expenses reasonably are expected to be incurred.

 Based on the foregoing reasoning, the judge rejected the homeowner's argument that overhead and profit must always be included in repair or replacement cost estimates. The judge then addressed State Farm's reasons (in Gilderman) for always deducting overhead and profit from its advance payments.

State Farm defended its actions first by observing that a contractor's costs are contingent and may never be incurred. It argued that it is unfair for an insured to receive advance payment for such expenses. The court responded to this argument with two observations:

(1) Contractor expenses may well be contingent; however, the same could be said of all repair or replacement costs. The court offered the example of where the insured may be a plumber who makes repairs himself and incurs no labor costs. The insured may be able to obtain materials at wholesale, used, or free of charge and never incur the retail costs of parts. All repair and replacement costs are, in theory, contingent prior to being incurred, the court said.

(2) The issue is not whether a given cost is contingent. The issue is what State Farm agreed to  pay to its insured prior to repair or replacement. It agreed to pay actual cash value, which means replacement cost new less depreciation. Thus, the real inquiry is what is included in "repair or replacement costs."

The court held that repair or replacement costs include any cost that an insured is reasonably likely to incur in repairing or replacing a covered loss. In some instances, this will include use of a general contractor and his 20 percent overhead and profit.

Like State Farm in Gilderman, Safeco in Mee complained that its named insured did not use a general contractor, so he did not incur overhead and profit. To pay the named insured overhead and profit, therefore, would result in a windfall. (The trial court had expressed this same concern.) The court addressed this issue as follows:

State Farm offered a second rationale for its practice [of never including overhead and profit], arguing that an insured would receive a windfall if permitted to recover a repair or replacement cost which may never be incurred. In this respect, we note that insureds under these policies have paid an additional premium for replacement cost coverage so that an insured can afford to repair or replace a loss at current market value and essentially keep the value of his property the same. . . It can hardly be said that an insured reaps a windfall by obtaining payment of actual cash value determined in a fair and reasonable manner when that is precisely what the insurer had agreed to pay under its policy in advance of actual repair or replacement.

No windfall occurs where the insured receives benefits for which he has paid and to which he is entitled, even if repair or replacement costs are not incurred.

In Gilderman, the court did not adopt a "bright line rule" for determining when an insurer should pay overhead and profit based on a number of trades required to make repairs. The court, instead, established an objective standard by which an insurer may determine on a case-by-case basis whether to pay overhead and profit—payment of overhead and profit is required where use of a general contractor would be reasonably likely. The court also suggested certain factors be considered in reviewing the insurer's decision regarding payment of overhead and profit, for example, the extent of the property damage, the number of trade required to repair the damage, and expert evidence of building industry standards regarding the correlation between use of a general contractor and the number of trades required to repair the damage.

From Gilderman, the court stated the following principles:

• Actual cash value includes repair and replacement costs.
• Repair and replacement costs include overhead and profit where use of a general contractor is "reasonably likely."
• Because a homeowner pays higher premiums for repair and replacement coverage, he is entitled to overhead and profit, where use of a general contractor is reasonably likely, even if no contractor is used or no repairs are made.
• Expert testimony about industry standards may be used to answer whether use of a general contractor is reasonably likely; and
• Whether use of a general contractor is reasonably likely depends on the nature and extent of the damage and the number of trades needed to make the repairs. This last principle necessarily requires consideration of the degree of coordination or supervision of trades required to make repairs.

 Returning to the Mee case, the record established the following:

1. The named insured paid premiums for a full value repair or replacement policy;
2. The named insured sustained a covered loss;
3. The insurer agreed to pay its named insured the actual cash value for repair or replacement;
4. Multiple trades were needed to repair the damage to the named insured's bathroom, stairwells, family room, and foyer: plumbing, flooring, drywall, carpentry, painting, and electrical; and
5. The named insured presented expert opinions as to when use of a general contractor was reasonably likely.

Applying the Gilderman principles to the Mee case, the named insured was found to be entitled to the benefit for which it contracted with its insurer; that is, overhead and profit, if the named insured could establish that use of a general contractor would be "reasonably likely." That the named insured chose to—or was required to—make the repairs himself did not necessarily preclude him from recovering overhead and profit. Viewing the evidence in light most favorable to the named insured, the court concluded that a genuine issue of material fact existed as to whether use of a general contractor would have been reasonlikely under the facts of this case. The court also concluded that there was a genuine issue of material fact whether the insurer acted in bad faith by not paying overhead and profit on the named insured's claim. Because these were questions for the jury to decide, the court remanded the questions for further proceedings.

 A Confusing Subject to Many

Based on the decisions of the courts and insurers' methods in making adjustments on property claims where contractors' overhead and profit is the subject of dispute, it appears that confusion is rampant among insureds and insurers alike. In one case, the adjuster testified that he was not trained to explain to an insured what overhead and profit was, when they may be entitled to it, and that overhead and profit was not a policy benefit. Interestingly, too, this same insurer's internal documents revealed a company policy to pay overhead and profit up front on all applicable actual cash value claims in accordance with a desire for "uniformity throughout our organization." Yet, there was conflicting evidence in the record on the timing of the insurer's overhead and profit payments based on the employees' testimony.

There is no denying that when insureds purchase homeowners policies on a replacement cost basis, they are paying for overhead and profit. Why then are they not paid a portion of those costs at the time the insurer pays the actual cash value and the remaining part when the property is fully repaired or replaced? It certainly makes more sense than for insurers to argue they are not paying for overhead and profit, along with actual cash value, unless it is reasonably likely the insured will use a general contractor to conduct its repairs. It is doubtful that insureds would complain if they were given a portion of the contractor's overhead and profit at the time with the actual cash value payment and the remainder when the property has been repaired.

Most cases appear to deal with personal lines insurance. Perhaps because losses involving commercial risks are usually large, there is no question but that insureds will reasonably be likely to use contractors to repair the work. It can also be concluded that there is no simple answer to the question of whether an insurer will pay overhead and profit, the amount paid, whether it is advanced with an actual cash value payment and with an additional sum when the property has been fully repaired, or totally advanced at the time of an ACV payment as long as its looks reasonably likely that a contractor will do the work. Overhead and profit continues to be controversial subject without any conclusion in sight.

Original publication:  September 17, 2012

Reviewed: February 8, 2023