Overhead & Profit

Adjusters International Disaster Recovery Consulting

EDITOR’S NOTE Overhead & Profit: In the property insurance claim, there Its Place in a Property Insurance Claim is occasional room for debate between policyholders and their insurers. Questions may arise about what to repair or replace, or there can be uncertainty over the fairest and most reasonable methodology used to calculate actual cash value (ACV).

There might also be discussions over which expenses contribute to an ACV estimate — labor, materials and one that readers of our feature article might find particularly interesting and useful — general contractor overhead and profit (GCO&P).

In this issue of Adjusting Today, attorney and first-party property insurance expert Edward Eshoo Jr. takes on those insurers that “... withhold, exclude, deduct or fail to include the costs of general contractor overhead and profit, GCO&P, in their calculation of the repair or replacement cost …” By Edward Eshoo Jr. Citing compelling case law, state insurance commissioner bulletins, An interesting discussion is now would dispute that labor and and accepted insurance industry taking place in the insurance materials are elements comprising practices, Eshoo brings us an insightful discussion of the various conditions industry over general contractor repair or replacement cost. But and circumstances that support the overhead and profit and its what about general contractor inclusion of GCO&P in the cost to rightful place in the property overhead and profit? Before repair or replace. insurance claim. answering this question, it helps to have a clearer understanding of We hope you find this information The terms “repair cost” or the role of the general contractor helpful. “replacement cost” are not clearly and exactly what falls into the defined in the typical property category of general contractor Sheila E. Salvatore insurance policy. Nevertheless, overhead and profit. Editor no reasonable property insurer ADJUSTING TODAY

A general contractor oversees While most property insurers rule, depreciation is deducted the entire construction project, provide replacement cost coverage, from the estimated cost to repair or a role that includes, among rarely are they contractually to replace damaged or destroyed other responsibilities, hiring obligated to pay more than property to determine its ACV. the required trades (carpentry, actual cash value (“ACV”) as of masonry, plumbing, electrical, etc.); the time of the loss unless and Depreciation in an insurance sequencing, coordinating and until the damaged or destroyed context, which is different than supervising their work; researching structure is actually repaired or depreciation in an accounting zoning requirements; and obtaining replaced. Since the term is usually context, is considered the decrease necessary permits. Overhead undefined in the typical property in the actual value of property expenses represent those costs insurance policy, courts have based on its physical condition, incurred by a general contractor developed three primary rules to age, use, and other factors that to operate its business, but are not measure ACV. affect the remaining usefulness of attributable to any one specific job. the property. Some courts apply a “market Some examples of overhead value” rule: the difference Although there is no express expenses are: between the market value of the provision in the typical property • general and administrative property before and after a loss. expenses This rule applies the criterion of • office rent and utilities what a willing buyer would pay • office supplies and what a willing seller would Determining ACV • salaries and benefits for office accept for the property on a cash Some courts apply a “market personnel sale in a free and open market. value” rule, which is the • depreciation on office difference in a free and open equipment Other courts apply a “broad market between the market • licenses evidence” rule, in which value of the property before and • advertising consideration is given to every fact after a loss. and circumstance that logically Other courts apply a “broad Every general contractor is entitled tends to establish a correct estimate evidence” rule, which to a profit, which is defined as of the value of the property, such as: considers every logical the difference between the cost its original cost; its replacement or fact and circumstance in of goods and the price for which reproduction cost; its market value; establishing a correct estimate they are sold. Overhead and income derived from its use; its age of the property’s value. These profit, which vary significantly and condition; its obsolescence, could include original cost, replacement cost, market value, in the construction industry both structural and functional; age and condition. from general contractor to depreciation and deterioration to general contractor, is expressed which it has been subjected; and the A number of courts have as a percentage of the total opinion of value given by qualified rejected both of these rules construction cost. The overhead expert valuation witnesses. and instead are applying a and profit percentage commonly “replacement cost less depreciation” rule. Under this utilized in the insurance industry is A number of courts have rejected rule, depreciation is deducted 20 percent of the estimated repair both the “market value” and the from the estimated cost to or replacement cost. “broad evidence” rules, instead repair or to replace damaged or applying a “replacement cost less destroyed property in order to depreciation” rule. Under this determine its ACV.

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insurance policy authorizing them to do so, some insurers withhold, exclude, deduct or fail to include the costs of GCO&P in Every general contractor their calculation of the repair or replacement cost used to arrive at “ is entitled to a profit, an ACV estimate and settlement of which is defined as the a claim based on the replacement cost less depreciation rule. difference between the cost of goods and the These insurers take the position that the overhead and profit price for which they costs of a general contractor are sold. Overhead and are not components of repair profit … is expressed or replacement cost unless and until they are actually incurred. as a percentage of the They maintain that an insured total construction cost. could receive what amounts to a windfall if permitted to recover ” a repair or replacement cost that may never actually be incurred.

However, opposing points of no general contractor is used or no ACV payment to policyholders view from respectable insurance repair or replacement is made. The irrespective of whether they industry professionals have been nature and extent of the damage actually repaired or replaced the circulating for some time now. and the number of trades needed damaged or destroyed property. Recent case law and two separate to make the repairs are key Accordingly, the issue in those state insurance commissioner factors in determining whether cases was the amount the insurer bulletins, along with long-accepted use of a general contractor is agreed to pay to its insured prior customs and practices in the reasonably likely. This requires to actual repair or replacement. insurance industry, conclusively some consideration of the degree It agreed to pay ACV, which the establish that GCO&P should be to which coordination and courts in those cases decided included in the cost of repair or supervision of trades are required. meant “repair or replacement cost replacement in order to arrive at an less depreciation.” ACV estimate and settlement. A number of cases that went before the courts involved In the 1994 case of Gilderman v. State Majority View: Payment replacement cost policies. Farm Ins. Co., the court stated, “the Required if Use is Likely However, the policies expressly real inquiry is what is included The majority of courts that provided that until the damaged in repair or replacement costs,” have considered the issue have or destroyed property was which it answered as “any costs concluded that payment of actually repaired or replaced, the that an insured would be expected GCO&P is required where the insurer’s obligation was limited reasonably to incur in repairing or use of a general contractor is to an ACV payment. Under the replacing the covered loss.” reasonably likely in repairing or policies in those cases, the insurer replacing a covered loss, even if also was obligated to make an

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The nature and extent of the damage and the number of trades needed “to make repairs are key factors in determining whether use of a general contractor is reasonably likely.” In the more recent case of Lukes v. court concluded in Mee v. Safeco explained that the estimate of the American Family Mutual Ins. Co., Ins. Co. of America, it can hardly ACV is just that — an estimate. the court observed, “The policy be said “that an insured reaps a Certainly, the insured has not at issue in this case does insure windfall by obtaining payment of incurred the cost of contractor’s the Plaintiff in ‘the amounts it actual cash value determined in a overhead and profit at this point would cost to repair or replace fair and reasonable manner when or, for that matter, the cost of labor covered property with material that is precisely what the insurer or materials. Logically speaking, of like kind and quality ... .’ Note has agreed to pay under its policy it makes no more sense to exclude that the policy does not say, ‘the in advance of actual repair or one on the grounds that it is a “non- amount which it did cost to repair replacement. No windfall occurs damage factor” and not the other. or replace ... .’ Thus, the Court where insureds receive benefits for rejects the Defendant’s argument which they have paid and to which But even more importantly, by that it does not have to pay sales they are entitled, even if repair or applying the “minority view” tax unless and until the Plaintiff replacement costs are not incurred.” logic, an insured who opts not to actually replaces the contents.” repair or to replace the damaged Minority View: Payment Not property would not incur any In its ruling in Tritschler v. Allstate Required Unless Incurred expenses, including the cost of Ins. Co., the court offered some A minority of courts have rational- building materials. As such, the additional perspective on the ized that overhead and profit are insured would collect nothing issue. It wrote that “actual cash “non-damage” factors that have under an ACV settlement, thereby value is an estimate of the needed no relation to the value of the rendering coverage illusory. repairs; the determination of damage. In their dim view, these actual cash value is not based represent only the cost or expense The two “minority view decisions“ upon what the insured actually that would be incurred if repair or — Karl v. State Farm Fire and pays to repair or replace the replacement were involved. Casualty Co., and Snellen v. State damaged property. Therefore, the Farm Fire and Casualty — also were amount an insured ultimately That rationale has been roundly based on an application of the spends to make needed repairs, if criticized in at least four cases. “broad evidence” rule, for which any, is irrelevant.” Finally, as the The “majority view” courts have there is no single measure of ACV.

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As the Karl court reasoned, the do not appear to be grounds for • overhead and profit broad evidence rule is “fatal to the State Farm to have refused to pay • miscellaneous direct costs position that, as a matter of law, the ‘overhead and profit’ which such as permits and taxes general contractor’s overhead and is part of the replacement cost profit must always be included as of the property. The ‘actual cash Widely accepted construction part of the ACV in each instance value’ of the property allows for estimating publications like where a general contractor could a deduction for ‘depreciation,’ Marshall & Swift/Boeckh, RS Means, be necessary to actually complete but under no legal definition, and Sweets that are used in the the repairs.” nor policy definition, is there a insurance industry in estimating provision for a separate deduction the replacement cost of commercial State Insurance for overhead and profit.” buildings and residential Commissioner Rulings dwellings, define replacement cost Quite impressively, the Texas Industry Custom and Practice to include labor, materials, and Department of Insurance took Textbooks commonly used in contractor’s overhead and profit. action and squarely addressed the the insurance industry include propriety of State Farm deducting contractor overhead and profit To add even further validation, the contractor’s overhead and profit as a component of repair or Property Loss Research Bureau from replacement cost when replacement cost. Property (PLRB), a recognized resource used calculating ACV. Loss Adjusting is a textbook by insurers in the interpretation for property claims adjusters of property insurance policy In a bulletin issued June 12, 1998, published by the Insurance provisions, has taken the position the Commissioner of Insurance Institute of America for use in that “contractor’s overhead and strongly articulated the position its industry-wide insurance profit are included in ACV, because of the Texas Department of designation and certification they are part of replacement cost.” Insurance relative to such practice: programs. It lists the following The PLRB concludes that “any “The deduction of prospective elements as comprising repair or estimate of actual cash value should contractors’ overhead and profit replacement cost: include overhead and profit.” and sales tax in determining the • materials actual cash value under a • labor and employers’ burden Other industry groups are taking replacement cost policy is • tools and equipment similar positions. The Fire, Casualty improper, is not a reasonable interpretation of the policy language, and is unfair to insureds.” The majority of courts that have considered The Colorado Division of “ Insurance lent support to that the issue have concluded that payment position when it fired off a missive of GCO&P is required where the use of a declaring its own stance on the issue. In a June 4, 1998, letter to general contractor is reasonably likely in a State Farm representative, the repairing or replacing Colorado Division of Insurance a covered loss, even wrote: “Based on the provisions in if no general contractor is used or no repair the policy, and the legal definitions of ‘replacement cost,’ ‘actual cash or replacement is made. value,’ and ‘depreciation’ there ”

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& Surety Bulletins (FC&S), a based on the replacement cost contractor/subcontractor overhead National Underwriter Publication less depreciation rule, even if the and profit when estimating the used by insurance professionals insured is not reasonably likely to replacement cost that determines in the interpretation of property incur such costs. the limit of liability upon which a insurance policy provisions, is one policyholder’s premiums are based. notable example. In response to a One reason is that many insurers question describing the practice of include the cost of specialty As the Texas Department of not including the costs of GCO&P contractor and subcontractor Insurance so aptly stated in as part of an ACV payment, an overhead and profit as well as its bulletin, “if the insurer in FC&S editor explained: sales tax in its replacement cost determining actual cash value and ACV calculations, even if excludes costs that are included “Both [general contractor overhead the contractor is not used and in the determination of liability and profit as well as subcontractor even if building materials are limits, on which the insured’s overhead and profit] are to be used not purchased. As a result, many premium is based, the insurer in calculating final replacement insurers pay for replacement costs reaps an illegal windfall because cost, since they are obviously a policyholders never incur: those the insurer receives premium on part of the function of repairing being the theoretical expenses insurable values for which loss or replacing the building, and it is of specialty contractors or may never be paid.” from this that the actual cash value subcontractors and sales taxes. settlement is derived.” Let’s also not forget that, as a Once again it goes back to cardinal rule of insurance contract An FC&S editor applied this same the simple premise that it is interpretation and construction, rationale in response to another illogical for insurers to include if a provision in an insurance question about an insurer’s refusal some, but to exclude other, policy is subject to more than to include architect’s fees in its “contingent” expenses in its one reasonable interpretation, replacement cost payment: replacement cost calculation. In then it is ambiguous and must be “When the home was new, the Gilderman, it was ruled that “All construed against the insurer and replacement cost on the first policy repair or replacement costs are, in in favor of the insured. included the architect’s fees, theory, ‘contingent’ prior to being because they were surely included incurred.” Likewise, in Mazzocki, The reasons for this rule are in the purchase price. Rebuilding the court stated, “A replacement two-fold: is no different. The replacement cost estimate is equally hypothetical cost of a home includes everything or contingent as to all materials, • The intent of an insured in that goes into it — not just the labor and contractor services.” purchasing an insurance policy building materials. The architect’s is to obtain coverage and, fees should be paid as part of Additionally, there is no real therefore, any ambiguity that replacement cost.” meaningful distinction between may jeopardize such coverage general contractor overhead and should be construed consistent Why GCO&P Always profit and that of the specialty with the insured’s intent. Should Be Included contractor/subcontractor. Arguably, there is no basis for an Overhead is overhead and profit • The insurer is the drafter of the insurer ever to exclude the costs of is profit. policy and could have drafted GCO&P from the replacement cost the ambiguous provision calculation that is used in arriving Furthermore, many insurers clearly and specifically. at an ACV estimate and settlement include both general and specialty

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Arguably, there is no basis for an insurer ever to exclude the costs of “ GCO&P from the replacement cost calculation that is used in arriving at an ACV estimate and settlement based on the replacement cost less depreciation rule, even if the insured is not reasonably likely to incur such costs.”

Following this analysis, it is reasonable expectation of indemnity. The role of insurance is a reasonable interpretation coverage in a situation in which to put insureds back into the same of the standard provisions in the insurer-draftsman controls the position they enjoyed before the the typical property insurance language of the policy — a court occurrence of an insured event. policy that the costs of GCO&P would be required to construe the should be included in every policy strictly against the insurer Now, just as various parts of loss estimated and settled and in favor of the insured. a property contain building based on the “replacement cost materials whose value cannot be less depreciation” rule. So in But as insurance industry excluded from ACV regardless accordance with this rule of professionals, let’s evaluate this of whether they are replaced, insurance contract interpretation issue in its purest sense. The each part of that property also and construction — a rule most fundamental of insurance contains at least some portion of designed to protect the insured’s principles is the principle of the original general contractor

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View our entire catalog of back issues, download PDF versions, subscribe and overhead and profit associated widely accepted insurance contact the editor with its construction. publications all acknowledge this fact. They clearly recognize the Because some of that value is left need to include these expenses at the time of the loss, the loss of in situations where the insured that value is, in fact, part of the is reasonably likely to incur such damage suffered by the insured. costs in repairing or replacing A claims practice of excluding, their loss. deducting or withholding the costs of GCO&P in these calculations Although many insurers routinely clearly violates the principle of pay for GCO&P if more than indemnity. Specifically, insureds three trade categories of specialty are not being compensated for the contractors/subcontractors are value included in that portion of needed, a strong argument can the general contractor overhead be made for including the costs Edward Eshoo Jr. Esq. and profit when the property was of CGO&P in every loss when the first constructed. replacement cost less depreciation Edward Eshoo Jr. Esq., is a founding rule is used. At the very least, partner of Childress Duffy Goldblatt, Conclusion Ltd. in Chicago, where his areas of insureds should receive some practice include insurance coverage, The inclusion of GCO&P in compensation for the time spent insurance producer malpractice, water ACV payments is pervasive and the expense incurred while damage and mold litigation, commercial litigation, and construction defect and traditional to the insurance acting as their own general litigation. For more than two decades, industry. Numerous courts of contractor in losses where the he has lectured on insurance-related topics and has authored articles and law, the Texas and Colorado services of a general contractor publications on first-party property departments of insurance and normally would not be utilized. insurance issues.

ADJUSTING TODAY is published as a public service by Adjusters International, Inc. It is provided for general information and is not CORPORATE OFFICE PUBLISHER 126 Business Park Drive Ronald A. Cuccaro, SPPA intended to replace professional insurance, Utica, New York 13502 legal or financial advice for specific cases. EDITOR 800.382.2468 Sheila E. Salvatore AT07-R1 3032 Outside U.S. (315) 797.3035 FAX: (315) 272.2054 Follow Adjusting Today on Facebook & Twitter: [email protected] Facebook.com/AdjustersInternational WEB ADDRESSES www.AdjustersInternational.com Twitter.com/AdjustingToday www.AdjustingToday.com