Class action litigation is spreading across the country involving the application of depreciation in calculating the actual cash value of property damage under homeowners and commercial property insurance policies. This blog post will be longer than typical, but I think you will find it worth reading.
The Issue: For decades, insurers have been using replacement-cost-less-depreciation as a method (where appropriate) for calculating actual cash value. That method typically takes the entire estimated replacement cost of an item of property (which includes the materials, labor and sometimes other components) and depreciates that item based on factors such as age, condition and obsolescence. Software programs such as Xactimate are often used in performing these calculations. Recently, putative class action cases in various jurisdictions have asserted that depreciation should be applied only to the materials component of the replacement cost, and not to the labor component. For example, if the cost of replacing a roof is $10,000 and $7,000 of that is labor and $3,000 is materials, then only the $3,000 should be depreciated, according to these plaintiffs.
Here is the status of the litigation in the jurisdictions where I’m aware of the issue being litigated, followed by some thoughts on options insurers have in addressing this issue. (If you are aware of any jurisdiction I’ve missed, please let me know.) There are also some jurisdictions where insurance department regulations have addressed the issue, such as California and Montana.
Arkansas: In 2013, the Arkansas Supreme Court ruled that “the cost of labor may not be depreciated when determining the actual cash value of a covered loss under an indemnity insurance policy that does not define the term ‘actual cash value.’” Adams v. Cameron Mutual Insurance Company, 430 S.W.3d 675, 679 (Ark. 2013). The court concluded that the term “actual cash value” was ambiguous, and that labor was not “logically depreciable” because it does not wear out over time. The court relied on a dissenting opinion in Redcorn v. State Farm Fire & Cas. Co., 55 P.3d 1017 (Okla. 2002). In that case, the majority of the Oklahoma Supreme Court had ruled in favor of the insurer’s position, explaining that under the “broad evidence rule” applied in Oklahoma and many other jurisdictions in determining actual cash value, it was appropriate to consider all relevant evidence in determining actual cash value. And the actual cash value of a roof, for example, would take into account the entire value of the roof as a completed product, not just the materials component thereof. For more on the Arkansas decision, see my November 21, 2013 blog post. This ruling led to numerous class actions being filed in Arkansas on this issue, some of which have resulted in class action settlements. There has been no ruling on class certification in Arkansas to my knowledge.
Kentucky: Last week, in Bailey v. State Farm Fire & Casualty Company, Civ. A. No. 14-53-HRW, 2015 U.S. Dist. LEXIS 37568 (E.D. Ky. Mar. 25, 2015), another putative class action on this issue, a Kentucky federal district court denied State Farm’s motion to dismiss. The court noted that a Kentucky regulation provides for actual cash value to be calculated as replacement cost less depreciation, but does not address how depreciation should be calculated. Id. at *11-12 (citing 806 KAR 12:095(9)). The court cited Kentucky law applying the principle of indemnity under which an insured receiving actual cash value payment should be “put back in the position he or she enjoyed before the loss,” without a benefit or detriment. Id. at *13. While the Oklahoma Supreme Court majority found that this principle supported the insurer’s position because depreciating only a portion of the value of an item would not yield its true actual cash value, the Kentucky federal district court disagreed. It wrote that “labor is not subject to wear and tear” because, for example, “the cost of labor to install a new garage would be the same as installing a garage with 10 year old materials.” Id. at *14-15. But is that the right question to ask? If the garage was for sale the day before the loss occurred, would a reasonable buyer pay the depreciated value of the garage in its entirety, or the depreciated value of the materials together with full labor costs? It would obviously be the former. The Kentucky court, however, agreed with the Arkansas Supreme Court decision, and the dissent in the Oklahoma Supreme Court.
Minnesota: In Wilcox v. State Farm Fire & Casualty Company, Civ. No. 14-2798 (RHK/FLN) (D. Minn. Mar. 4, 2015), a Minnesota federal district court recently decided to certify to the Minnesota Supreme Court the following question: “May an insurer, in determining the ‘actual cash value’ of a covered loss under an indemnity insurance policy, depreciate the costs of labor when the term ‘actual cash value’ is not defined in the policy?” The court directed the parties to submit proposed statements of facts to accompany the certified question.
Alabama: In Baldwin Mutual Insurance Company v. McCain, 2015 Ala. LEXIS 22 (Ala. Feb. 20, 2015), the Alabama Supreme Court recently reversed the certification of a class, on procedural grounds, in a case involving a labor depreciation issue. The insured alleged that it was improper to depreciate labor costs associated with the removal of damaged materials (some insurers do not apply depreciation to these costs), but apparently the insured did not challenge the depreciation of the labor costs associated with installing materials. The insurer’s summary judgment motion was denied by the trial court, and a class was certified. The Alabama Supreme Court reversed the certification of the class on procedural grounds. This was because the plaintiff, in a brief filed after the class certification hearing, sought to expand the scope of the class to include policyholders who had replacement cost policies, in addition to those who had actual cash value policies. The trial court had adopted this new class definition. The supreme court held that it was improper for the trial court to certify the class without giving the insurer the opportunity to oppose certification of this newly-framed class at a new evidentiary hearing. The Alabama Supreme Court did not address the merits of the issue presented or the merits of certification. So this decision is not likely to have impact elsewhere.
Missouri: There are several putative class actions where the labor depreciation issue has been raised in Missouri, but no ruling on the merits or class certification has been reached yet: Riggins v. Am. Fam. Mut. Ins. Co., Case No.: 2:14-cv-04171-NKL (W.D. Mo.); McLaughlin v. Fire Ins. Exch., No. 1316-CV11140 (Mo. Cir. Ct., Jackson Cty.); Bellamy v. Nationwide Affinity Ins. Co., No. 1516-CV06346 (Mo. Circ. Ct., Jackson Cty.).
So what options might insurers consider on this issue, given that it seems to be gaining traction in the plaintiffs’ bar and spreading across the country? Here are the options that I can think of:
Litigating Vigorously: Although a couple of decisions have gone against the industry, there should be still plenty of hope that the tide can be turned. In jurisdictions that have adopted the “broad evidence rule” or “fair market value” as the method of calculating actual cash value, there is a strong argument that a market value calculation intrinsically takes into account depreciation of the overall market value of a building, including both labor and materials. Insurers can also rely on the manner in which depreciation is calculated in other relevant contexts, such as appraisal of real property for tax purposes. These appraisals typically apply depreciation to the entire value of the structure, and this method is frequently upheld by courts. Leading appraisal textbooks also provide for that type of calculation. Arguments focused on a broader, more comprehensive analysis of the jurisdiction’s law on actual cash value and depreciation may persuade courts that the insurance industry’s longstanding approach of depreciating the entire replacement cost value of an item is the correct approach, and a more accurate method of determining actual cash value. Insurers also have a host of arguments in opposing class certification, including that age, condition and obsolescence of items must be litigated on a case-by-case basis, and determining how depreciation was applied on a claim and how the claim was handled (whether on a replacement cost or actual cash value basis or some combination thereof) requires a file-by-file review. Both liability and damages may require individualized adjudication.
Modifying Policy Language: At least one insurer has adopted policy language specifically permitting the application of depreciation to labor costs. If approved by the insurance department (where required), this is likely to be effective in resolving the issue on a going-forward basis. But changing policy language will not resolve the issue when raised under older policy forms that do not have the new language. And plaintiffs sometimes argue that a change in policy language means that the old version was ambiguous (although courts have repeatedly rejected that argument). An insurer that changes its policy language would still face the risk of a putative class action alleging that, under the prior policy provisions, depreciation of labor costs was improper. The only way to try to preclude that risk would be to issue retroactive payments on closed claims that are not time-barred, which would be expensive.
Seeking Regulatory Guidance: Insurers might consider asking insurance departments to opine on this issue, but they risk the possibility of an adverse result. And the department may not have the authority to regulate where the issue involves construing policy language and applying existing court precedent. Seeking regulatory guidance is probably not likely to happen unless the insurer has reason to believe the department’s answer will support its position. Insurers will need to be prepared, however, for the possibility of increased regulatory activity in this area in light of the class action litigation.
Changing Practices: Insurers could avoid this issue prospectively by changing their practices nationwide, or in certain jurisdictions, so as not to depreciate the labor component of replacement cost value in calculating actual cash value. But that would be expensive. And unless the change were implemented retroactively by reopening closed claims and issuing supplemental payments, such a change would not prevent the possibility of a successful class action seeking to recover labor depreciation amounts on claims within the applicable suit limitation period (or contractual limitations period). And defending those suits might be more difficult where the practice has been changed. No matter how well documented, the fact that a change is made might create the wrong impression about the correctness of the prior practice.