An Illinois appeals court weighed in on whether a homeowners insurer may depreciate labor as a component of replacement cost when calculating an insured’s recovery on an actual cash value basis.
Specifically, the court analyzed whether labor, as a component of replacement cost, may be depreciated when calculating actual cash value where Illinois Department of Insurance Regulations describe actual cash value as replacement cost of property at time of loss less depreciation while the insurance policy is silent as to the definition of that term or the manner in which replacement cost is depreciated to arrive at actual cash value. The court held that it may not: Where the state’s insurance regulations define “actual cash value” as “replacement cost of property at time of loss less depreciation, if any,” absent a definition of “actual cash value” in the policy itself, the damaged structure and materials are subject to a reasonable deduction for depreciation, while intangible labor is not. (Sproull v. State Farm Fire & Casualty Company, 2020 IL App (5th) 180577)
That this was a novel issue of first impression under Illinois law is something of a novelty in itself. Whether labor is a depreciable component of replacement cost is the subject of a well-established split of authority not only in courts across the country but also in the field and training grounds where the industry’s experts and adjusters are taught their trade. Whether Sproull got the answer right or wrong, whether other components of replacement cost such as tax, permits, overhead and profit are, or should be depreciable under other state’s laws and different policy language is a question for another day. This article analyzes Sproull, the reach of its holding under Illinois law, and what it requires—and does not require—of carriers currently writing business in Illinois.
The Sproull’s home was damaged by wind. Their insurer, State Farm, acknowledged coverage for the loss and estimated that it would cost $1,711.54 to repair the damage. Like any replacement cost policy, the Sproull’s policy provided for loss settlement in two phases. First, State Farm would pay the “actual cash value at the time of the loss of the damaged part of the property.” While the policy did not define “actual cash value,” regulations promulgated by the Illinois Department of Insurance defined it as “replacement cost of property at time of loss less depreciation.” 50 Ill. Admin. Code 919.80(d)(8)(A). State Farm calculated the depreciation as $394.36. Accordingly, after deducting the $1,000 deductible, State Farm paid the Sproulls $317.18. Notably, neither the policy nor the department regulations defined “depreciation” or explained what components of replacement cost were subject to depreciation. If and when the Sproulls repaired or replaced the damage to their home they were entitled to recover the withheld depreciation in the amount of $394.36.
State Farm provided the Sproulls with an Explanation of Benefits (EOB) and line-item estimate explaining the two-phased loss settlement of their claim. The estimate, prepared using an industry-standard software program called “Xactimate,” reflected a total repair or replacement cost of $1,711.54 which, less depreciation of $394.36, yielded an actual cash value of $1,317.18. The EOB accompanying the estimate explained that the Sproull’s policy provided replacement cost coverage, but that in order to recover the full repair or replacement of their loss the Sproulls had to, among other things, actually repair or replace the damaged part of the property within two years of the date of loss. Until then, the Sproulls were only entitled to recover the actual cash value of the damaged part of the property. In summary, the EOB stated that:
The estimate to repair or replace your damaged property is $1,711.54. The enclosed payment to you of $317.18 is for the actual cash value of the damaged property at the time of loss, less any deductible that may apply. We determined the actual cash value by deducting depreciation from the estimated repair or replacement cost. Our estimate details the depreciation applied to your loss. Based on our estimate, the additional amount available to you for the replacement cost benefits (recoverable depreciation) is $394.36.”
On Sept. 23, 2016, the Sproulls filed a putative class action complaint in Madison County, Illinois, alleging that State Farm breached its contractual obligations to plaintiff and to similarly situated policyholders by improperly and deceptively depreciating the cost of intangible components of replacement cost, such as labor.
Just over a year before filing Sproull, part of the same legal team teed up precisely this issue in a putative class action filed in the Circuit Court of Cook County, Jenkins v. State Farm Fire & Cas. Co., 15 CH 8242 (May 21, 2015). While the trial court dismissed that case for failure to file suit within one year period required by the policy, an appeal was pending in the First District Appellate Court when Sproull was filed in Madison County.
State Farm moved to stay the proceedings in Madison County pending the Illinois Appellate Court First District’s ruling in Jenkins. Alternatively, State Farm moved to dismiss for failure to state a claim on the ground that its practice of depreciating labor was consistent with the terms of its policy and Illinois Department of Insurance regulations.
Proceedings were briefly stayed in deference to Jenkins, but resumed just three months later when the First District Appellate Court affirmed the Circuit Court of Cook County’s dismissal on the ground that the insured failed to file suit within the one-year period required by the policy. See 2017 IL App (1st) 160612-U. After supplemental briefing, the court denied State Farm’s motion to dismiss, finding the undefined phrase “actual cash value” ambiguous in the context of State Farm’s policy and therefore construing it in Sproull’s favor.
At State Farm’s request, the trial court certified the following question for interlocutory review pursuant to Ill. Sup. Ct. R. 308(a):
“Where Illinois’ insurance regulations provide that the ‘actual cash value’ or ‘ACV’ of an insured, damaged structure is determined as ‘replacement cost of property at time of loss less depreciation, if any,’ and the policy does not itself define actual cash value, may the insurer depreciate all components of replacement cost (including labor) in calculating ACV?“
The Fifth District’s Opinion
While the certified question encompassed all components of replacement, including labor, the parties’ arguments in the trial court and in the court of appeal addressed only whether labor could be depreciated. Reformulating the certified question as referring to labor only, the Fifth District answered: “‘No.’ Where Illinois’s insurance regulations provide that the ‘actual cash value’ of an insured, damaged structure is determined as ‘replacement cost of property at time of loss less depreciation, if any,’ and the policy does not itself define actual cash value, only the property structure and materials are subject to a reasonable deduction for depreciation, and depreciation may not be applied to the intangible labor component.”
This author would be remiss not to mention that the court cloaked its reasoning in the fundamental purpose of a contract of indemnity, which is “to place the insured in as good a position, as reasonably practicable, as he would have been had the loss not occurred.” The court related that principal to the two-step process for settlement of losses under State Farm’s replacement cost policy:
“The homeowners policy at issue provided for replacement costs for structural damage and contained a two-step process for settling a covered loss. In step one of the process, which applied prior to the completion of the actual repair or replacement of the damaged property, State Farm was to pay the actual cash value, at the time of the loss, of the damaged part of the property. Thus, State Farm was obligated to indemnify plaintiff, thereby placing plaintiff in the position he enjoyed prior to the loss. In step two, which applied when the repairs were completed, State Farm was to make additional payments for the actual and necessary repairs to the damaged property.”
As State Farm’s policy did not define “actual cash value” or “depreciation” the court looked to Illinois case law, Department of Insurance regulations, and dictionary definitions. Under Illinois law, the court noted, there is no question that “actual cash value” “begins with a determination of the ‘cost of replacement’ of the damaged property,” and “has always allowed for a deduction for depreciation of the property based on age.” (citing Smith v. Allemannia Fire Insurance Co. of Pittsburgh (announcing that it would follow the rule that stated that “actual cash value” means “reproduction value less depreciation for age and not market value.”); C.L. Maddox, Inc. v. Royal Ins. Co. of Am. (holding that “actual cash value means reproduction costs less depreciation for age and not market value.”); and Carey v. Am. Fam. Brokerage, Inc. (holding that proper calculation of actual cash value under Illinois law and insurance policy at issue was “replacement cost less depreciation.”)).
The court also cited Carey’s explanation, ostensibly from Black’s Law Dictionary, that “depreciation in an insurance context, rather than an accounting context, mean[s] ‘the decrease in the actual value of property based on its physical condition, age, use, and other factors that affect the remaining usefulness of the property.’” Another dictionary, the court noted, defines “depreciation” as “a reduction in value of an asset with the passage of time, due in particular to wear and tear.” To top it off, the court pointed out that the Illinois Department of Insurance regulation describing actual cash value does so in terms of replacement cost of property, i.e. something tangible, owned, or possessed. Thus, the court continued, “it is clear, based upon the plain language of the State Farm policy at issue and the language in the Code that ‘actual cash value’ refers to real property—an asset that can lose value over time due to wear and deterioration, resulting from use or the elements, and does not refer to services, such as labor.”
In light of the foregoing, the Sproull court held that “the plain, common, and ordinary meaning of depreciation is a reduction in value of a property because of aging and wear and tear to the physical structure of that property.” The court found that “based upon the plain language of the State Farm policy at issue and the language in the Code that ‘actual cash value’ refers to real property—an asset that can lose value over time due to wear and deterioration, resulting from use or the elements, and does not refer to services, such as labor.”
The court thus summed up its holding as follows:
“In answering the certified question before us, we remain mindful that we must consider whether the average, ordinary, reasonable person, for whom the policy was written, would have understood that the “actual cash value” of a covered loss meant replacement costs of property less depreciation for materials and labor. We think not. We conclude that an average, ordinary homeowner who purchased the State Farm policy at issue would have reasonably expected that depreciation would apply only to property, i.e., physical structures and tangible materials, as those lose value with age, use, and wear and tear. We further conclude that it is not reasonable to believe that an average homeowner would consider labor to be a tangible asset included within the definition of depreciation.”
In addition to the briefs submitted by the Sproulls and State Farm, the Fifth District accepted amici briefs from the American Property Casualty Insurance Association, the National Association of Mutual Insurance Companies, and United Policyholders, much of which pointed the court to the approaches and rationale employed by courts in other jurisdictions. The court acknowledged the split of authority among other jurisdictions as to whether labor costs are depreciable in calculating actual cash value, citing a handful of decisions reflecting the divergent views other courts have taken, but abstained from commenting on the relative merits or flaws of those opinions, noting only that they “generally provide limited guidance.”
Analysis and Implications of Sproull
Despite the breadth of the question originally certified to the Fifth District its holding is comparatively narrow. Where Section 919.80(d)(8)(A) defines actual cash value as replacement cost of property at time of loss less depreciation, and the policy does not define actual cash value, labor is not a depreciable component of replacement cost.
Sproull is thus agnostic regarding depreciation of other components of replacement cost. Notably, in Gee v. State Farm Fire & Cas. Co., the U.S. District Court for the Northern District of Illinois, applying Illinois law, found that State Farm’s depreciation of sales tax when calculating the “cost to repair or replace less depreciation” was consistent with the clear intent of the policy. In doing so, the court noted that other courts had approved the practice of depreciating “[o]ther percentage-based elements” of replacement cost as well, including Goff v. State Farm Florida Insurance Co., which permitted depreciation of overhead and profit. In that regard it is noteworthy that in Sproull the Fifth District went out of its way to narrow the issue before it; reformulating the initially certified question—which referred to all components of replacement cost—to address only whether labor could be depreciated.
Even as to the labor component of replacement cost, the Fifth District limited its analysis to homeowners insurance policies. While the certified question made no reference to the type of insurance policy at issue, the court stated that it “involve[d] the interpretation of a personal homeowners insurance policy, drafted and issued by State Farm.” Section 919.80(d)(8)(A), the administrative regulation referenced in the certified question, applies only to settlement of losses on an actual cash value basis on “residential fire and extended coverage,” defined by statute to mean policies covering real property “used principally for residential purposes up to and including a 4 family dwelling…” 215 ILCS 5/143.13(b); C.L. Maddox, Inc. v. Royal Ins. Co. of Am. (finding that predecessor to 50 Ill. Admin. Code 919.80(d)(8)(A) defining “actual cash value” as “reproduction costs minus depreciation” “is inapplicable to commercial property”.)
Perhaps most importantly, State Farm’s policy did not define “actual cash value,” “depreciation,” or otherwise explain what components of replacement cost would be depreciated to arrive at actual cash value. Sproull, thus, does not preclude insurers from defining “actual cash value” or “depreciation” in their policies to explicitly allow for depreciation of labor. Indeed, State Farm submitted policy forms utilized in Illinois by other insurers, and so necessarily approved by the Department of Insurance, which explicitly informed the insured that in calculating actual cash value the insurer may depreciate all components of replacement, including but not limited to the costs of material and labor.
The question to the industry posed by Sproull is not how to comply with its holding going forward. Many insurers did not depreciate labor in Illinois anyway, and for carriers that did, the adjustment going forward may be as simple for some as checking or unchecking a box in Xactimate or other estimating software program. But those who have recently depreciated labor in Illinois can expect to hear from insureds, public adjusters, and attorneys who will contend the practice is prohibited by Illinois law and is evidence of unreasonable or vexatious conduct for which the insurer may be liable under Section 155 of the Illinois Insurance Code.
The appropriate response from carriers will vary with the facts and circumstances of each claim. Whether a claim was closed after an undisputed payment, a disputed payment, or an amount determined in appraisal, whether the property was repaired or replaced, whether some or all recoverable depreciation was released, whether the claim is in litigation, or the time for filing suit or claiming replacement cost benefits has passed, are all variables that need to be taken into account in dealing with insureds who, like Sproull, feel they did not get the benefit of their bargain. Even those carriers who do not traditionally depreciate labor in Illinois will need to take care that their adjusters, particularly independent adjusting firms, are on the same page when it comes to the what, why, and how they are depreciating the various components of replacement cost.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Matthew P. Fortin is a partner at BatesCarey LLP.
Any opinions expressed in this article are not necessarily the views of BatesCarey LLP or its clients.