Insurance policies are designed to indemnify an insured by putting the policyholder in the same position he or she would have been in had no loss occurred. In the context of property insurance policies, damaged property is typically valued based on its estimated actual cash value (ACV) if it is not repaired or replaced. In order to calculate ACV, an insurer will often calculate the replacement cost (RCV) based on the cost to repair or replace the property with materials of like kind and quality, and then depreciate that amount to account for age, wear, obsolescence, or market value. When making that calculation, there can be a question as to whether labor should be appreciated. In Lammert v. Auto-Owners (Mutual) Insurance Co., No. M2017-02546-SC-R23-CV (Tenn. Apr. 15, 2019), the Supreme Court of Tennessee joined the states that have ruled that labor cannot be depreciated.
To Depreciate Labor or Not
In this case, the petitioners filed a putative class action seeking a ruling that Auto-Owners impermissibly depreciated labor when calculating ACV under certain homeowners policies. When calculating ACV, Auto-Owners acknowledged that it depreciated both materials and labor.
There were two policies at issue. One defined ACV as “the cost to replace damaged property with new property of similar quality and features reduced by the amount of depreciation applicable to the damaged property immediately prior to the loss.” The second policy did not define ACV, but stated that actual cash value includes a deduction for depreciation. The policyholders argued that these definitions do not allow for depreciation of labor “because labor is intangible, and ‘prior to the loss’ likewise eliminates labor costs because the labor costs at issue are post-loss costs.” The policyholders also pointed to the definition of “depreciation,” which was defined as “a decrease in value because of age, wear, obsolescence or market value,” to argue that labor cannot be depreciated “because it does not age, wear out, become obsolete, or (generally speaking) decrease in market value.” In response, Auto-Owners argued that the policies are not ambiguous and “that depreciation of a property is taken from the total replacement cost, which includes both labor and materials.”
The district court determined that the dispute over whether labor can be depreciated is a question of state law for which there was no controlling precedent, and certified the following question to the Tennessee Supreme Court:
Under Tennessee Law, may an insurer in making an actual cash value payment withhold a portion of repair labor as depreciation when the policy (1) defines actual cash value as “the cost to replace damaged property with new property of similar quality and features reduced by the amount of depreciation applicable to the damaged property immediately prior to the loss,” or (2) states that “actual cash value includes a deduction for depreciation”?
The Question of Indemnity
The question of coverage is always determined by the policy terms and conditions. Insurance policies are interpreted based on their plain language. However, if the language at issue is susceptible to more than one reasonable interpretation, a policy will be considered ambiguous and is most often construed in favor of the insured and coverage.
The Tennessee Supreme Court noted that “[c]entral to the discussion in this opinion are the concepts of indemnity, actual cash value, and depreciation.” Insurance policies, as contracts of indemnity, are intended “to reimburse the insured; to restore him as nearly as possible to the position he was in before the loss” (quoting Braddock v. Memphis Fire Ins. Corp., 493 S.W.2d 453, 459-60 (Tenn. 1973)). When property is damaged, “if an insured were able to replace a loss ‘with a substitute identical in kind and quality’ then ‘complete indemnity’ would be accomplished” (quoting McAnarney v. Newark Fire Ins. Co., 159 N.E. 902, 904 (N.Y. 1928)). Because such substitution is often not possible, “indemnity is instead accomplished through recovery of the actual cash value of a damaged property.”
The court observed that there are several methods for calculating ACV, including market value, replacement cost less depreciation, and the broad evidence rule. In this case, the parties agreed that the method for calculating ACV was replacement costs less depreciation.
What they disagree on is whether depreciation applies only to the materials or to both materials and labor. The homeowners claim that applying depreciation to both materials and labor defeats the indemnity purpose of insurance by not making the homeowners whole, while Auto-Owners counters that applying depreciation only to materials results in a windfall to the homeowners, thus also defeating the purpose of indemnity.
The court reviewed decisions from around the country that have come down on either side of the question presented. Some courts find that labor cannot be depreciated. See, e.g., Titan Exteriors, Inc. v. Certain Underwriters at Lloyd’s, London, 297 F. Supp. 3d 628 (N.D. Miss. 2018); Arnold v. State Farm Fire & Cas. Co., 268 F. Supp. 3d 1297 (S.D. Ala. 2017); Brown v. Travelers Cas. Ins. Co. of Am., No. 15-50-ART, 2016 WL 1644342 (E.D. Ky. Apr. 25, 2016); Lains v. Am. Family Mut. Ins. Co., No. C14-1982-JCC, 2016 WL 4533075 (W.D. Wash. Feb. 9, 2016). Other courts find that labor can be depreciated, or at least that the depreciation of labor can be considered when determining ACV. See, e.g., Graves v. Am. Family Mut. Ins. Co., 686 F. App’x 536 (10th Cir. 2017); In re State Farm Fire & Cas. Co., 872 F.3d 567 (8th Cir. 2017); Henn v. Am. Family Mut. Ins. Co., 894 N.W.2d 179 (Neb. 2017); Redcorn v. State Farm Fire & Cas. Co., 55 P.3d 1017 (Okla. 2002). In addition, “[t]he Minnesota Supreme Court took a third approach to answering the issue by determining that the depreciation of labor costs is an issue of fact rather than law” (citing Wilcox v. State Farm Fire & Cas. Co., 874 N.W.2d 780, 785 (Minn. 2016)).
The court noted that the most recent appellate court to address the issue was the Sixth Circuit Court of Appeals in Hicks v. State Farm Fire & Casualty Co., 751 F. App’x 703 (6th Cir. 2018). In that case, “the Sixth Circuit concluded that under Kentucky law, the term ‘actual cash value’ was ambiguous, not because it was undefined but because the word ‘depreciation’ as used in the statutory definition of ‘actual cash value’ was itself ambiguous.” The court based this finding of ambiguity on the fact that the parties presented two reasonable interpretations of the word depreciations — one allowing depreciation of both labor and materials, and one allowing depreciation of materials only. The Sixth Circuit found that those cases allowing depreciation of both labor and materials were typically in states following the broad evidence rule for determining ACV.
While Auto-Owners argued that Tennessee is a broad evidence state, the Supreme Court stated that it had never adopted the broad evidence rule. Rather, it had “merely acknowledged that the broad evidence rule and the replacement-cost-less-depreciation method both accomplished indemnity.” Moreover, the court determined that whether Tennessee is a broad evidence state is not at issue since the parties agreed that actual cash value was to be calculated based on the replacement cost method.
Turning to general principles for interpreting insurance contracts, the Tennessee Supreme Court found that “both parties have presented plausible interpretations of the policies, neither of which explicitly states whether labor expenses are depreciable when calculating the actual cash value.” The court decided that Auto-Owners argued for a “technical definition” of depreciation that is not evident on the face of the policies, while taken in its “ordinary sense” depreciation means “physical depreciation,” which is the meaning that the court found had been attributed to it by the policyholders. As a result of its determination that the provisions were susceptible to more than one reasonable interpretation, the court found the provisions ambiguous and construed them in favor of the insured, holding that “depreciation can only be applied to the cost of materials, not to labor costs.”
Auto-Owners argued “that if the homeowners’ interpretation is correct, then indemnity is not accomplished because instead of receiving the actual value of their property in terms of money, the insured would never receive less than the cost of the labor, even if the labor was worth more than the actual property prior to the loss.” In contrast, the policyholders argued that “depreciating labor costs would underindemnify the insureds because they would bear the out-of-pocket costs of reinstalling the damaged asset.” The court did not address the indemnification dispute holding:
Ultimately, it is not necessary for this Court to reach the decision of whether labor can logically depreciate or whether indemnity is accomplished. It is enough that we find the contracts ambiguous and that under our standard of review, the interpretation of the insured must prevail. We conclude that the answer to the district court’s certified question is no, the insurance company cannot withhold a portion of the labor costs as depreciation under either policy.
As an initial matter, it is worth noting that this decision left open the question of whether Tennessee is a broad evidence state. The regulations promulgated by the Tennessee Department of Insurance further leaves this question open. While it provides that “[w]hen the insurance policy provides for the adjustment and settlement of losses on an actual cash value basis on residential fire and extended coverage, the insurer shall determine actual cash value as follows: replacement cost of property at time of loss less depreciation, if any,” it also states that “[i]n cases in which the insured’s interest is limited because the property has nominal or no economic value, or a value disproportionate to replacement cost less depreciation, the determination of actual cash value as set forth above is not required.” Tenn. Comp. R. & Regs. 0780-01-05-.10(2) (effective Oct. 2017). Giving an insurer an alternative to calculating ACV, when replacement cost less depreciation does not seem to provide an appropriate valuation, suggests that broad evidence can be considered in at least some instances in Tennessee.
The case also arguably leaves open the question of whether labor can be depreciated if an insurance policy specifically defines depreciation as including the depreciation of labor. In this decision, the court noted multiple times in reaching its decision that the policies did not state whether labor expenses could be depreciated. Without controlling language in the policy, the court held that the insurance provisions were susceptible to more than one interpretation, making them ambiguous and construed in favor of the insured and coverage. If, however, the policy defined depreciation as including labor, it is not clear from the face of the opinion that such a provision would not be upheld. Again, the scope of coverage should be governed by the specific language of the policy