As an update to his analysis on the deprecation of labor in replacement cost policies published in Bloomberg Insights in October 2020, Matthew P. Fortin discusses actual cash value and depreciating labor following the Illinois Supreme Court’s ruling in Sproull v. State Farm Fire & Casualty Company.

Introduction

On September 23, 2021, the Illinois Supreme Court affirmed the Fifth District Appellate Court of Illinois’ answer to the certified question of 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. See Sproull v. State Farm Fire & Casualty Company, --- N.E.3d ---, 2021 IL 126446, affirming 172 N.E.3d 1186, 2020 IL App (5th) 180577. The answer is no: where Illinois' 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.” Id. at ¶ 41.

That said, the ruling is somewhat narrower than the certified question presented and the Court’s answer to it make it appear. It applies only to homeowners insurance policies, and arguably not even to personal property claims under those policies. This article discusses the scope of the Court’s ruling, its significant departure from the Fifth District Appellate Court’s reasoning, and the consequences for the valuation of property claims in Illinois not only in the future, but also those that are ongoing or even recently concluded.

Background

The Sproull’s home, insured under a homeowners policy issued by State Farm, was damaged by wind. State Farm estimated it would cost $1,711.54 to repair the damage. Because it was a replacement cost policy, the Sproulls were entitled to the actual cash value of the loss – less the applicable deductible – up front, plus an additional amount in the form of withheld depreciation if and when they completed repairs. After accounting for the $1,000 deductible and $394.36 in the form of withheld depreciation, State Farm cut the Sproulls a check for $317.18. If and when the Sproulls repaired the damage they were entitled to recover the withheld depreciation.

The parties’ dispute focused on State Farm’s calculation of actual cash value. Because the policy did not define ACV, the Illinois Department of Insurance’s definition of that phrase as “replacement cost of property at time of loss less depreciation, if any” controlled. See 50 Ill. Admin. Code § 919.80(c)(8)(A). State Farm deducted depreciation from some, but not all, labor costs that comprised its $1,711.54 estimate. Taking issue with that, the Sproulls filed a putative class action complaint in Madison County, Illinois, alleging that State Farm breached its contractual obligations by improperly and deceptively depreciating the cost of intangible components of replacement cost, such as labor.

The trial 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 the 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?

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. 2020 IL App (5th) 180577, ¶ 41. Reformulating the certified question as referring to labor only, the Fifth District answered: “‘No.’ Id. Drawing on the policy’s lack of definition of “actual cash value” or “depreciation,” Illinois case law, Illinois Department of Insurance regulations, and dictionary definitions, the appellate court concluded 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.” Id. at ¶ 39 (citations omitted).

The appellate court formally answered its reformulated certified question as follows:

“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.” Id. at ¶ 41.

The Supreme Court’s Opinion

From the outset, the Illinois Supreme Court made clear that the sole issue before it was “whether an insurer may depreciate labor costs in determining the “actual cash value” (ACV) of a covered loss when a homeowner's policy does not define that term.” Sproull at ¶¶ 1, 20.

The Landscape: As prelude to its analysis, the Court embarked on a wide-ranging discussion of the case law that has addressed this issue since the Oklahoma Supreme Court first did in Redcorn v. State Farm Fire & Casualty Co., 55 P.3d 1017 (Okla. 2002), fairly summarizing the authorities that have collectively drawn the landscape as it exists today.

The Court gave special attention to the first case to address this issue, Redcorn v. state Farm Fire & Cas. Co., 55 P.3d 1017 (2002), in which the Oklahoma Supreme Court sided with State Farm. Sproull at ¶¶ 21-22. The Illinois Supreme Court mentioned, but did not elaborate on the fact, that in Oklahoma actual cash value is determined by the “broad evidence rule,” which considers any and all relevant factors in determining ACV, such as purchase price, replacement cost, age, condition, market value, appreciation and depreciation. Id. at ¶ 23.

Redcorn rejected the notion that depreciation of labor would violate principles of indemnity, see Sproull at ¶ 24, stating that, “[p]ursuant to the broad evidence rule, a fact-finder is entitled to consider what the life of the destroyed roof, both materials and labor, would have been, as well as any other relevant evidence presented.” The majority, ultimately, believed that the plaintiff would be unjustly enriched if his argument were accepted. (internal citations omitted).

The dissenting opinions in Redcorn took the opposite view. See Sproull at ¶ 25 (“The dissent believed that, to properly indemnify the plaintiff, State Farm should pay him the value of the shingles, depreciated for wear and tear, plus the cost of their installation.  In the dissent's view, depreciating labor would leave the plaintiff with a significant out-of-pocket loss that was inconsistent with the principle of indemnity.”) (internal citations and quotations omitted).

“Justice Summers filed an additional dissent to offer the observation that, before the damage, the insured had a roof with 16 year-old shingles. Thus, the insured was contractually entitled to have on his house 16 year-old shingles or their value in money. Justice Summers argued that the insured should not bear any of the cost of installing the shingles, as that would prevent him from being made whole as if the damage had not occurred.” Sproull at ¶ 26 (internal citations and quotations omitted).

The Court noted that the majority and dissenting opinions in Redcorn drew the distinctions that still set the terms of debate on this issue today.

Those jurisdictions that have adopted the view that labor can be depreciated generally: (1) find the phrase ‘actual cash value’ unambiguous; (2) view materials and labor as an integrated product that it is not logical to separate when applying depreciation; and/or (3) tend to believe that not depreciating labor provides a windfall to the insured. Sproull at ¶ 28.

Jurisdictions where labor may not be depreciated, on the other hand, either: (1) find the phrase ‘actual cash value’ ambiguous, and therefore construe it in insureds’ favor; (2) view labor as not logically depreciable; and/or (3) find that it fails to fulfill the fundamental purpose of insurance of indemnity. See Sproull at ¶ 33.

The Parties’ Positions: The Fifth District Court of Appeal’s opinion placed Illinois in the latter camp, but in doing so went further than most, finding that the plain language of State Farm’s policy and Section 919.80(d)(8)(A) unambiguously precluded depreciation of labor when determining actual cash value. State Farm argued that the plain language of the policy and regulation not only allow labor to be depreciated, but provide no basis for drawing a distinction between material and labor in calculating actual cash value.

In the absence of a definition of either “actual cash value” or “depreciation” in State Farm’s policy, the Fifth District Court of Appeal had leaned heavily on an Illinois Department of Insurance regulation, 50 Ill. Admin. Code § 919.80(d)(8)(A):

When the insurance policy provides for the adjustment and settlement of losses on an actual cash value basis on residential fire and extended coverage…the company shall determine actual cash value, except for instances in which the insured's interest is limited as set forth in subsection (d)(8)(B), as follows: replacement cost of property at time of loss less depreciation, if any. Upon the insured's request, the company shall provide a copy of the claim file worksheet(s) detailing any and all deductions for depreciation, including, but not necessarily limited to, the age, condition, and expected life of the property.

50 Ill. Adm. Code 919.80(d)(8)(A) (2002) (emphasis added).

The Sproulls focused on the word “property” in the italicized portion of the regulation, arguing that the definition of ACV contemplated depreciation of only physical, tangible material and, therefore, precluded depreciation of labor – an intangible component of replacement cost.

State Farm meanwhile argued that the value of property, such as a house, is determined by viewing it as a fully assembled whole, rather than as the sum of its material components, and so “‘it makes little sense’ to ‘differentiate between labor and materials when calculating depreciation.’” Appellant’s Br., 2021 WL 2209449, at *20-21 (quoting Accardi v. Hartford Underwriters Ins. Co., 838 S.E.2d 454, 457 (N.C. 2020)). The phrase “depreciation, if any,” moreover, was meant to allow depreciation of any and all components of replacement cost. Id. at ¶ 43.

The Court’s Ruling: The Supreme Court seemingly found both the parties’ positions to be overstated, though not without merit. Reigning in the Fifth District’s conclusion that “the plain language of the policy and the regulation compels the conclusion that labor may not be depreciated,” the Court found that State Farm had offered “a perfectly reasonable interpretation of the policy and regulation reaching the opposite conclusion, and several state and federal courts have agreed with this position.” Sproull at ¶ 44.

Ultimately, the Court found the policy ambiguous as to whether labor may be depreciated when calculating actual cash value. Sproull at ¶ 49. “Several state and federal courts have held that the language ‘replacement cost less depreciation’ would not necessarily indicate to a reasonable insured that labor would be depreciated in determining ACV, and there are several reasons why this is the case.” Id.

First, “labor is not logically depreciable, as it does not lose value over time due to wear and tear. Materials deteriorate with time, but labor does not.” Sproull at ¶ 50 (citing Redcorn, 55 P.3d 101 (J. Boudreau dissenting)). “Labor is a fixed cost that is not subject to wear and tear, deterioration, or obsolescence.” Id.

Second, “depreciating labor can result in the insured being placed in a worse position than he was in before the loss. As several courts have noted, the labor cost of installing old materials would be the same as the cost to install brand new materials. Id. at ¶ 51. It follows that depreciating labor would fail to fulfill the principal of indemnity by putting the insured in a worse position after the loss than he or she had been before it. Sproull at ¶ 51 (citing Mitchell, Hicks and Adams).

Finally, the Court observed that State Farm’s actual practice – as illustrated by its calculation of the actual cash value of the Sproull’s loss – was more closely aligned with the insured’s understanding of actual cash value than the position State Farm was advocating for. Xactimate, the estimating software State Farm used to value the Sproull’s loss, allows a user to depreciate labor or not depreciate labor simply by checking a box. Sproull at ¶ 53. Using that capability, rather than depreciating the replacement cost of the Sproull’s damaged property as a whole, it depreciated some, but not all, of the labor costs in its estimate of the Sproull’s loss. Sproull at ¶ 53.

In summary, because the Sproulls had offered a reasonable interpretation of “actual cash value” which does not contemplate depreciation of the labor component of replacement cost when calculating ACV, the Court answered the certified question posed to it in the negative, finding that “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.” Sproull at *54.

Analysis and Implications of Sproull

Despite the seeming breadth of its opinion at first glance, the Illinois Supreme Court’s ruling in Sproull is actually relatively narrow.

First, it applies only to homeowners insurance policies. The regulation that supplied the definition of “actual cash value” under State Farm’s policy, Section 919.80(d)(8)(A), applies only to policies “cover[ing] real property used principally for residential purposes up to and including a 4 family dwelling…” 215 Ill. Comp. Stat. § 5/143.13(b).

That said, substantially similar definitions of “actual cash value” as that provided by Section 919.80(d)(8)(A) (“replacement cost of property at time of loss less depreciation, if any.”) have been applied by Illinois courts to commercial property policies that did not themselves defined “actual cash value” or “depreciation.” See, e.g., C.L. Maddox, Inc. v. Royal Ins. Co., 208 Ill. App. 3d 1042 (5th Dist. 1991) (affirming trial court’s definition of actual cash value as replacement cost minus depreciation and exclusion of evidence of fair market value at trial of fire claim under commercial property insurance policy that did not define actual cash value or depreciation); Carey v. Am. Fam. Brokerage, Inc., 391 Ill. App. 3d 273, 281-282 (1st Dist. 2009) (In case involving businessowners package policy, stating that “Illinois courts have rejected both the “market value” and the “broad evidence” tests, instead applying the aforementioned “replacement cost less depreciation” test in determining the actual cash value of damaged property.”); Smith v. Allemania Fire Ins. Co., 219 Ill. App. 506, 513 (1920) (“Actual cash value means reproduction value less depreciation for age and not market value.”). Given the Supreme Court’s reasoning in Sproull, there is little reason to believe the outcome would be any different if the undefined term “depreciation” is supplied by case law as opposed to an administrative regulation.

Second, insurers are free to define “actual cash value” and “depreciation” in homeowners policies issued in Illinois – subject to approval of the Department of Insurance just like any other form or endorsement – to explicitly allow for depreciation of any and all components of replacement cost, including labor. See Sproull, 2020 IL App (5th) 180577, ¶¶ 14-20 (describing homeowners policies issued by two other insurers in Illinois). Indeed, the Court’s opinion noted that State Farm had recently done just that. Sproull at ¶ 11 n.1.

Third, the Court’s ruling only applies to depreciation of the intangible labor component of replacement cost. See Sproull at ¶ 54. Depreciation of certain other components of replacement cost, such as sales tax and overhead profit, do not appear to be threatened by the Court’s ruling.

The only Illinois case law touching on those subjects is Gee v. State Farm Fire & Casualty Co., 2013 WL 8284483 (N.D. Ill. Sept. 23, 2013), in which the court held that sales tax was a depreciable component of replacement cost under a homeowners policy that entitled the insured to recover “the cost to repair or replace less depreciation” for lost or damaged property that the insured did not replace. Id. at *1. The court in Gee noted that sales tax, since it is generally calculated on a percentage basis, movies proportionately with the value of the taxed transaction. Other percentage-based elements of replacement cost, such as overhead and profit, the court noted, have been depreciated as part of replacement cost with approval in other jurisdictions. Id. at *2 (citing Goff v. State Farm Florida Ins. Co., 999 So. 2d 684, 689 (Fla. App. 2008)).

Both Sproull and State Farm discussed Gee in their briefs to the Illinois Supreme Court, with Sproull agreeing that “the sales tax on tangible personal property necessarily depreciates at the same rate as tangible personal property.” Appellee’s Br., 2021 WL 1669544, at *40 (Mar. 5, 2021).

Fourth, enterprising insurers may even find ways around Sproull itself. Section 919.80(d)(8)(A) contains a list of factors insurers may take into account when applying depreciation, “including, but not necessarily limited to, the age, condition, and expected life of the property.” By providing a non-exhaustive list, the regulation clearly contemplates additional factors that may be taken into account when applying depreciation.

Finally, Section 919.80(d)(8)(A) contains an exception for “instances in which the insured's interest is limited as set forth in subsection (d)(8)(B).” That subsection, in turn, states as follows:

“In 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 in subsection (d)(8)(A) is not required. In such cases, the company shall provide, upon the insured's request, a written explanation of the basis for limiting the amount of recovery along with the amount payable under the policy.” 50 Ill. Admin. Code § 919.80(d)(8)(B).

See Perry v. Allstate Indem. Co., 953 F.3d 417, 422 n.4 (6th Cir. Mar. 18, 2020) (discussing purpose of substantially similar regulation in Ohio as to prevent windfall to insured); Hicks v. State Farm Fire & Cas. Co., 751 Fed. App’x 703, 711 n.5 (6th Cir. Oct. 15, 2018) (noting that substantially similar regulation in Kentucky “so as to prevent an absurd result or windfall for the insured…leaves open the possibility of using a fair market valuation, in which the trier of fact could consider labor depreciation as a factor.”)

Thus, when actual cash value calculated as “replacement cost less depreciation,” without depreciating labor, results in a seemingly inappropriate valuation relative to the economic value of the property, Section 919.80(d)(8)(B) may provide a relief valve – albeit an untested one under existing case law.

The potential need for a safety valve such as that provided by Section 919.80(d)(8)(B) when the “replacement cost less depreciation” formula for determining actual cash value produces an inequitable outcome is one reason to question the benefit of a “replacement cost less depreciation” to actual cash value as opposed to the flexibility of a market value or broad evidence rule approach. In Sproull, moreover, the Court acknowledged the sentiment in other jurisdictions that “labor depreciation makes sense only in states that apply the ‘broad evidence rule’ for determining ACV.” Sproull at ¶ 33. The Court even hinted at the difficulty of a principled analysis of the depreciation of labor under the “replacement cost less depreciation” approach when it remarked that whether or not it made “little sense” to treat materials and labor differently when calculating depreciation was mooted actual industry practice. Sproull at ¶¶ 52-53.

Whether for those reasons or others, the Court has seemed to invite the insurance industry or the Illinois Department of Insurance to take the issue into their own hands. See Sproull at ¶ 35 (noting multiple other states that had addressed depreciation of labor through administrative regulations or bulletins); ¶ 46 (noting that although “the regulation does not define depreciation” “State Farm has chosen not to define depreciation in the policy nor set forth how depreciation is to be calculated.”). When and how either of them do remains to be seen.

Any opinions expressed in this analysis are not necessarily the views of BatesCarey LLP or its clients.