A report released this month by global insurer Munich Re concludes that 2011 was the costliest year ever in terms of natural catastrophe losses. In the U.S., no part of the country was spared; there was a drought and wildfires in the West, historic flooding in the Midwest and Northeast, and tornados in the South. More troubling, the report shows a strong upward trend in both the number of catastrophes and the value of losses from 1980 to 2011.  Munich Re reports that less than one-third of the estimated $380 billion in global losses caused by these catastrophe events were covered by insurance.   

Businesses generally purchase so-called “replacement cost” coverage for natural catastrophe and other insured property losses.  This coverage, as its name indicates, is supposed to pay the policyholder to replace its lost or damage property (as opposed to merely paying the “actual cash value” of the lost or damaged property). “Replacement cost” is generally defined as the cost to repair or replace the lost or damaged property with other property of “like kind and quality.”

Unfortunately, a business faced with an insured loss often discovers that its insurance company’s view of “replacement cost” doesn’t necessarily include all costs associated with replacing the lost or damaged property. For example, insurers often argue that the replacements for certain lost or damaged property amount to an “upgrade” for which they are not liable. In addition, insurers often argue that certain costs associated with rebuilding – such as the cost of studies and permits required by local building laws and ordinances, or other ancillary costs associated with rebuilding, such as architect and engineering fees – are not covered by their policies.

Most courts hold that the fact that the policyholder receives the benefits of newer or more modern replacement property is inherent in the concept of replacement cost coverage and, therefore, the insurance company cannot deduct or offset anything for those ancillary benefits.  See, e.g., Travelers Indem. Co. v. Armstrong, 442 N.E.2d 349, 352 (Ind. 1982) (“[r]eplacement cost coverage … reimburses the insured for the full cost of repairs, if he repairs or rebuilds the building, even if that results in putting the insured in a better position than he was before the loss.”); Rockford Mut. Ins. Co. v. Pirtle, 911 N.E.2d 60, 65 (Ind. Ct. App. 2009) (“Any purported windfall to an insured who purchases replacement cost insurance is precisely what the insured contracted to receive in the event of a loss.”). Whether the replacement property is “like kind and quality” to the lost or damaged property, however, is often a hotly contested issue. 

Another common issue is whether the cost of complying with laws and ordinances required to repair or replace lost or damaged property is covered. Some policies contain exclusions for these types of costs; and other policies contain added coverage for these types of costs.  The language of these provisions often differs from policy to policy.

The day after the Munich Re report mentioned above was issued, the United States Court of Appeals for the Ninth Circuit asked the California Supreme Court to answer two important questions related to these costs under California law: 

1. Whether under California insurance law, a building ordinance or law exclusion, found in the Perils Exclusions section of a property insurance policy, effectively excludes coverage for increased costs caused by complying with ordinances and regulations if the underlying loss was caused by a covered peril. 
2. Whether, under California insurance law, the costs of obtaining building permits or conducting required environmental impact studies are considered costs excluded by a building ordinance or law exclusion, or whether these costs are better considered as part of the replacement cost under the policy. 

Sierra Pacific Power Co. v. Hartford Steam Boiler Inspection & Ins. Co., No. 09-16662 (9th Cir. Jan. 5, 2012).  

The Sierra Pacific Power case involved the destruction of the Farad Dam during flooding of the Truckee River. Sierra, the operator of the dam, was informed by the California State Water Resources Control Board that replacing the dam would require detailed environmental studies, which resulted in design changes and required moving the dam. In addition, numerous permits and easements were necessary to comply with these requirements. The costs associated with these requirements exceeded $4 million.

Sierra’s property insurance policy, like many policies, contained an exclusion for increased loss due to any ordinance or law affecting the repair or replacement of the dam. It also contained a common coverage extension referred to as “Demolition and Increased Cost of Construction” (DICC) coverage, which covers certain additional loss and costs associated with the requirements of building laws and ordinances. Sierra’s insurer argued that any coverage for the $4 million in additional costs associated with rebuilding the Farad dam were limited to any coverage provided by the DICC coverage and were otherwise excluded by the policy’s ordinance or law exclusion. The Ninth Circuit rejected the argument that the DICC coverage limited the coverage otherwise afforded by the policy. However, the court certified to the California Supreme Court the question of whether the building ordinance exclusion applied to exclude the increased costs associated with rebuilding the dam, noting that, “[w]hile these costs were required by ordinances or regulations, it is unclear whether California would consider these costs, which are prerequisites to building rather than actual increased construction costs, to be within the Building Ordinance Exclusion.”  The resolution of this issue will be critical to California policyholders, because these are common provisions in property insurance policies.

Sierra Pacific Power illustrates the importance of understanding what rebuilding costs your property insurance policy will cover in the event of an insured loss. In the wake of the costliest year ever for natural catastrophe losses, it is a good time to review your property insurance policies and understand the coverage they will provide in the event of an insured loss.