Andrew Hooker reveals what the Courts have ruled on how indemnity and replacements provisions must be handled by insurance companies. How have insurers treated you?

By Andrew Hooker*

Among the hard luck and tragic stories out of the Christchurch earthquake, come some interesting developments in the way insurance policies are interpreted are emerging.

Recent cases are considering just what the term 'indemnity value' means and when the insurer has to pay. Immediately following the earthquakes many of the disputes between insurance companies and their clients related to whether an event was covered.

Many of these disputes have now been resolved, and the issues arising before the Courts relate to how much the insurance company has to pay.

As can be expected, the insurance companies want to minimise their payments, and as a result, are applying interpretations to provisions in policies that best favour the insurer.

In most commercial building policies, the policy holders are covered for replacement conditions. It is very unusual these days in New Zealand to find an insurance policy covering a commercial building that does not provide for replacement cover.

The old type of “indemnity” policies are unusual. However, what most policy holders are not aware of is the way these policies work in practice.

Most commercial policies actually provide a primary cover for indemnity value, with a 'add-on' for replacement value.

The “add-on” for replacement value provides quite strict conditions as to when the replacement value must be paid.

Almost all replacement value add-ons state that the insurance company does not have to pay for the replacement amount (over and above the indemnity amount) until that cost is actually incurred.

What this means is that until the insured person decides to actually rebuild, the insurance company has no obligation to pay any more than the indemnity value.

The corollary is that the obligation to pay the indemnity value arises as soon as the loss occurs. In other words, the 'base policy' provides cover for indemnity value, and that amount is payable as soon as the claim is accepted.

This can of course be extremely helpful if the insured is carrying a large mortgage over the property, so that the insured can at least reduce interest exposure in the period before the building is actually reinstated.

Unfortunately, some insurance companies are somewhat reluctant to accept the obligation to immediately pay the indemnity value.

A number of tactics appear to be employed by insurance companies include:

1. attempting to withhold all payments until the insured commences reinstatement; or

2. offering an indemnity payment on a 'without prejudice' basis; or

3. calculating the indemnity payment on an incorrect basis.

It seems inevitable that there will be litigation around this point before too long.

Many insurance companies, when calculating the indemnity payment they are required to make, will simply ask a valuer to provide a “market value” estimate. Unfortunately, most valuers are used to providing market value estimates for sale and purchase purposes and will calculate the market value based upon what the land and buildings would be worth (willing buyer willing seller) less the land value.

This is not the correct basis for calculating indemnity value for an insurance policy.

The indemnity value of a building is the value of the building to the insured immediately before the loss.

So if, for example, the insured was using the building as a going concern for its business, it must be valued accordingly.

If the insured owned the property as a commercial landlord, it is that value that should be taken into account.

To simply provide for a market value in the strict sense is not correct.

This has been widely accepted by the Courts in New Zealand and Australia, and in the United States the Courts are well and truly used to calculating indemnity values based on what is called the “broad evidence rule”.

What that means is that the indemnity value (or “actual cash value” as it is called in the United States) is based upon a consideration by the Court of many factors that will provide evidence which has a legitimate tendency to prove the fact of the value of the property. These factors can include the original cost of the building, the cost of restoration or replacement of the building less depreciation, the age of the property, the economic value of the property, the income derived from the property, the profit likely to accrue on the property and any other evidence which may possibly throw light on the actual value of the building at the time of the loss.

Given that the purpose of indemnity insurance is to “indemnify” the insured person for the insured person’s loss, this is surely the correct approach.

To simply apply a market value based on what you could obtain for a property if it was sold, is totally inappropriate if the insured was not planning to sell the property.

So if you are contemplating settling or negotiating with your insurance company in relation to a destroyed commercial property, remember that under most policies you will be entitled to receive the indemnity value immediately. After that, the remainder is paid once the building is reinstated.

This raises another point.

Some insurance companies are simply refusing to pay more than the indemnity value until the insured actually goes about rebuilding.

But when the insurance company is refusing to pay what is believed to be the real cost of rebuilding (“we can repair this building rather than demolish it”) it is impossible for the insured to actually commit to rebuilding without the assurance of payment from the insurance company.

Many insured people are finding themselves in this situation, a kind of Catch-22 in which they are expected to start rebuilding, even though the insurance company is wrongfully refusing to pay the actual cost of rebuilding.

Again, the Courts have considered this situation, and there have been ample cases in which the Courts have said that an insurance company cannot rely on the obligation to rebuild as a bar to payment where the insurance company has wrongfully failed to performed under the policy.

This can be a technical and difficult area. But fundamentally:

• If you have a replacement commercial policy, it is quite likely that you are entitled to the indemnity value immediately;

• If the insurance company doesn’t pay the indemnity value when you are entitled to receive it, you may be entitled to claim from the insurance company interest that you incur as a result of the late payment;

• Do not accept “willing buyer willing seller” market value as the basis of indemnity value;

• If the insurance company is refusing to rebuild, when clearly the building cannot be repaired, it cannot expect you to start your rebuild until it accepts its proper obligation under the policy.

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*Andrew Hooker practices as a specialist insurance lawyer in Albany on Auckland's North Shore. He is also director of Claims Information Specialists Ltd, an insurance information website.