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Actual cash value perpetuates undefined conclusion

Actual cash value perpetuates undefined confusion

The Canadian Appraiser/Spring 1996


When faced with determining the meaning of actual cash value, confusion abounds, especially amongst "non insurance" practitioners in the valuation, legal or financial fields, when, in the interests of justice, the term actual cash value will be modified in accordance with one's view of the circumstances of the individual case at hand.

For example, in the case of Swanson and Swanson v. Economical Mutual Insurance Company 1 the insurer denied liability on the grounds that the insureds caused the loss through arson.

The insurance policy in that case defined actual cash value thus:

The actual cash value will take into account such things as the cost of replacement less any depreciation, and in determining depreciation, will consider the condition immediately before the damage, use of the property, the resale value and the normal life expectancy.

In arriving at its judgement, the court focused on the resale value component of the definition, almost to the exclusion of the reproduction cost less depreciation method.

Perhaps the definitive work on this subject has been written by Brown and Menezes in their treatise entitled Insurance Law in Canada.

Paraphrasing the Colonsay Hotel Co. decision, Brown and Menezes contend, quot;that actual cash value means the cost of reinstatement less depreciation, unless circumstances indicate another more appropriate measure." 2

Recognizing the imperfection of this definition as it relates to valuation problems resulting from the different circumstances of individual cases, the authors suggest dividing the approaches to value into the following five categories:

1. The cost of repairs;

2. The cost of buying a substitute;

3. The cost of making a substitute;

4. The diminution in value resulting from the damage; or

5. The loss of commercial value. 3

In their subsequent discussion, the authors state that, in the first category, there may be instances where "repairs are physically possible but legally prohibited, (eg. municipal bylaw) the insured may recover for loss of the entire (insured) property." 4

Their further discussion about "effecting repairs to mean depreciation" can be interpreted as the difference between betterment to the property after the repairs, as compared to the state of the property prior to the damage, resulting in increased net rent, which presumably, when capitalized, will be deducted from the cost of effecting the repairs.

For example, if the condition of the walls and ceilings of a damaged commercial building was such that, prior to the damage, the economic rent was $10/sq.ft. a year, and, after building new walls and ceilings, the indicated economic net rent increased by $1/sq.ft. a year, then the capitalized net rent could exceed or equal the cost of effecting the repairs, and the insured could get nothing.

Apparently, in an attempt to protect insureds from capricious or unsupported judgements by experts quantifying depreciation, the New Brunswick Court of Appeal 5 sought evidence supporting an increase in the (market) value resulting from replacement of the part destroyed before a deduction for depreciation could be made.

The proposition arises that, where a commercial property is insured for replacement value in an area suffering from chronically soft rental demand, the undepreciated replacement value of the insurable improvements could equal their actual cash value on the basis that there would be no change to the net operating income resulting from the replacement of the property.

According to Brown and Menezes, where it is deemed inappropriate to replace or repair the damaged property, the leading Canadian case dealing with the foregoing problem is the Canadian National Fire Insurance Company V. Colonsay Hotel Co. 6, in which Justice Anglin stated:

[Actual cash value means] The actual value of the property to the insured at the time of loss, having regard to all conditions and circumstances then existing, not necessarily its market value on the one hand and certainly not, on the other, its replacement value which, while it may sometimes be less than its actual value to the insured, will more often exceed that value and sometimes, as in the present instance, very grossly exceed it The right of recovery by the insured is limited to the actual value destroyed by fire.

The judge rejected market value and replacement value, and by inference, subjective value to the owner.

Regrettably, authors Brown and Menezes do not specify what value is to be quantified, nor do they define value. Yet, they do provide an approach to use in such situations to quantify the loss described as the diminution in value approach, which is the "difference between the value of the property at the time of the occurrence of damage, and its value after the damage was inflicted." 7

But what value should be considered? If not market value, replacement value, or replacement value less physical depreciation, is it liquidation value, investment value, or perhaps salvage value? Each will probably produce significantly different results because each, by definition, is distinct.

Intrinsic value, loosely interpreted by some as being the subjective value to the owner, has been advanced by insurers in some disputes where it could, be demonstrated that the insured building improvements were actually of little value to the insureds.

Brown and Menezes explain that in such circumstances, as in Cyrand Investments Ltd. v. Aetna Ins. Co., the courts have allowed a capital amount for the building, plus the amount for rents that would have been collected had the building continued to exist.

In practice, investment real estate is capable of producing a net operating income, even if its location may be better suited to another use that would replace the existing use.

The law in this case, as explained by Brown and Menezes, could result in double recovery if the inexperienced appraiser was inclined to capitalize the income stream twice, i.e., if he or she capitalizes the income stream to represent the present capital value of the insured improvements and adds to that the present worth of the projected income stream. Attempts at double recovery have occurred in the past, and that is why there are statutory rules against it.

Terms like capital value, rental value and commercial value are referred to frequently by the courts Like actual cash value, however, these terms are referred to without being defined, thus making approaches to quantification of such values pre-sumptuous on the part of valuers, and inciteful to dispute.

Depending upon the indications of the insurance policy, if, under the circumstances the owner intends to rebuild, one would reasonably apply replacement cost new, in like kind and quality, or that, less physical depreciation only, to represent capital value of the insurable real estate's reversionary interest. One might interpret rental value to be the present value discounted of the projected net operating income stream, derived from the contract rent over its most probable horizon, for the insurable improvements.

The valuation problem will become esoteric if the lease term of one or two tenants is prolonged more than five years beyond the date of the building's destruction by fire, and which consequently protracts the entire presumed revenue production for the same period. The quality and durability of the income stream derived from the short-term rentals not under lease will result in significant subjective judgements on the part of valuers concerning roll-overs, vacancy and collection loss.

If a party purchases property knowing it was encumbered by a lease with three or five remaining years, that remaining single lease term should establish the horizon period of an income approach to value, discounting the present worth of the projected net operating income stream and employing a replacement cost less physical depreciation projected for the fifth year. This would represent the insured owner's interest in the property at the end of the lease period.

In estimating market value by such an income approach, the reversionary interest would normally be based upon a capitalization of the sixth year's income. Because this is an insurance issue, and market value itself is not intentionally the value sought, it is appropriate to use the replacement cost less physical depreciation for the reversionary value indication.

Cost of substitution

The principle of substitution, which states "that a prudent person will not pay more for a property than the cost of acquiring an equally desirable substitute," is the primary principle upon which the cost and sales comparison approaches are based. 8

In Cavuga Materials & Const. Co. v. Aetna Casualty & Surety Co., it was decided that, where the damage to the insured property is so extensive that the cost of buying an available substitute is less than the cost of rebuilding, then the latter will normally be the measure of recovery. This measure is commonly called market value since the insured can take that sum into the market and buy the substitute. 9

It would appear that the requirement to estimate market value as a representation of actual cash value stems from these principles for buying or making an equally desirable substitute property.

However, these original principles attempted to equate the market value of the substitute insurable improvement with the actual cash value of the insured improvement, especially if the insured improvement was deemed to have been destroyed beyond repair. 10

This observation is in line with a fundamental principle of insurance enunciated by John Purdon, A.S.A. Valuation Consultant for Marsh & McLennan, Inc., New York, N.Y.

Restoration or Reimbursement For Loss.

Insurance against fire and other causes of property damage is generally carried to make good the loss to the insured of what he possessed immediately before the occurrence of this loss. This involves either restoration in like kind and quality, or reimbursement only to the extent of the damage. It does not imply substitution or replacement of what is lost with What is to be desired in lieu of the damaged or destroyed property, unless special provision has been made in the contract of insurance.

Subsequent court decisions have amplified the confusion, perhaps due to a misinterpretation of the original intent of estimating the substituted property's market value to represent the amount of the loss, where the extent of the damage has been beyond repair. In equating the cost of buying an equally desirable substitute building with the actual cash value of the insured building in question, in the minds of some, the insured property's actual cash value came to equal its own market value.

Depending upon the circumstances, this may be true. However, in dealing with complicated situations involving commercial or industrial properties, different trade-offs and adjustments between insured and insurer will occur for a substitute property as compared to the subject property.

This has certainly happened in New Brunswick courts. In the Swanson case, for example, the court equated listing price less land value as representing actual cash value, 11 and in a subsequent case, justice Paul Creaghan ruled as follows:

Where the owner does not intend to rebuild, as was the case here, the actual cash value for the total loss of the dwelling is to be assessed by the market value approach and not by the reproduction costs less depreciation method. 12

In both the Swanson and Fox cases, the insured properties consisted of single family dwellings.

When estimating market value, its commonly accepted definitions impute or specify several criteria and/or qualifications that premise a conclusion of value.

A typical comprehensive definition, found in appraisal texts and supported by case law, is as follows:

Market value is defined as being the highest (most probable) price in cash or terms equivalent to cash, as of a specified date, that a property will bring, if exposed for sale on the open market, allowing a reasonable time to find a prudent, fully informed willing purchaser, buying from a prudent, full informed willing vendor, both knowing all of the uses to which the property is capable of being put, both acting for self interest, neither party under duress. 13

In this definition, from an insurance valuation perspective, (a) use and (b) willing vendor require discussion.

A. Use

If both parties to a transaction know all of the property's possible uses, it implies that both will recognize the highest and best use of the property and arrive at market value on that basis, if they are prudent, full informed, acting in their self-interest and not under duress.

Highest and best use is defined as being "the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value. The four criteria that highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum profitability." 14

In practice, especially in the valuation or trade of commercial or industrial properties, the specific highest and best use warrants the demolition of the existing building improvements to make way for a redevelopment of the land to its optimum use.

It is conceivable that the property owner of the existing use operates his business profitably from the property, although it is not the optimum use of the land. Suppose, for example, the property is destroyed by fire. The owner is 68 years of age, and one year's redevelopment time will reasonably result in too great a loss of clientele to competitors, causing the insured to decide not to rebuild.

Guided by the Fox decision, the appraiser treats the insured improvements as being nearly fully depreciated, with almost all of the market value of the property vested in the land. The insured receives minimal insurance money, goes out of business, and must sell the land to recover the loss.

By comparison, the values for residential properties will usually not suffer a similar fate, although there are examples that indicate it can happen.

B. Willing vendor

A common fault in real estate valuation and appraisal is the ignorance among practitioners and users of appraisals concerning the concept of the willing vendor, a fundamental criterion and premise of any market value definition.

The idea that market value is determined from the standpoint of the buyer has become so pervasive that many appraisers no longer question whether or not a prudent, fully-informed vendor acting for self-interest and not under duress would be willing to sell his or her property at the buyer's subjective price conclusion. They consequently ignore the vendor's reasonable interests, supported by market evidence, by valuing the property entirely from the stand-point of the buyer. This is investment value and not market value.

A true application of market value, as defined herein, requires that the appraiser include, analyze and interpret all of the factors impacting upon value from the vendor's standpoint, as well as the buyer's.

Such factors, of course, must be quantifiable or at least identifiable from market data or precedent. Sentimental value is never a valid consideration in arriving at market value. The vendor, however, may enjoy a special economic advantage, which could be a valid value consideration.

Another criterion for estimating the vendor's selling price could be a reasonable expectation for growth or appreciation of value, which would not have been considered from the standpoint of the "typical buyer."

In describing the relationship between market value and actual cash, value in 1968, John Purdon said:

In estimating market value, the presence of obsolescence, both economic and functional, must always the reflected in the estimate of value. In insurance appraisal, the general rule is that where a property is being used for the purpose, for which it was designed, or is useable for that or another purpose, obsolescence is not a factor in estimating depreciated insurable value. 15>

How relevant is purchase price?

A commonly known legal principle, apparently supported by some cases referred to herein in the application of insurance or expropriation law, is that against betterment, i.e., that the party suffering the loss should not be re- stored to a position that leaves him better off than he was before the event causing his loss. One notes that it should not leave him in worse circumstances either.

In insurance situations, it is also apparent that the purpose of the rule against betterment is to discourage acts of arson. Unfortunately, there are many examples where, after total destruction by fire, the insured has been inadequately compensated for loss due to the ways in which these technicalities have been applied.

For example, is it appropriate, in light of the principle against betterment, to deny the insured any actual cash value for the insurable improvement if the building was destroyed by fire and all of the value was deemed, in the opinion of the valuer, to be in the land, simply because the insured's purchase price equated with the land value of the property at the time of the building's destruction?

Apart from purchase price, the remaining criteria stipulated in the Ziola decision, i.e., the use being made of the property, its sale, (market?) value, age and obsolescence, condition, location and the opinions of experts, should outweigh any resulting consideration below the otherwise indicated market value of the improvements. This is especially true if the purchase price has been unduly influenced by duress on the part of the vendor, or by the vendor not dealing at arm's length, perhaps including in the consideration natural love and affection. This is also true if the existing building suits the purchaser's intended use, and the cost of replacing that building new, at the same location, would be two or three times the cost of acquiring the whole property.

The investigation into actual cash value has revealed the following:

a) Most insurable real estate is insured for full replacement value in the event of total loss by fire or other insured peril.

b) If the insurance contract is, in the event of total loss by fire (or other), written for actual cash value, and the insured intends to rebuild, then unless otherwise qualified by the contract, actual cash value means replacement in like kind and quality, less physical depreciation.

c) In the event the actual cash value definition of the insurance contract includes obsolescence as part of its definition, then actual cash value may be interpreted as meaning market value.

d) In the event the insured decides not to rebuild, actual cash value will be interpreted as being market value.

e) if an equally desirable substitute property exists for purchase within the market place, the actual cash value of the insured property may be determined, based on the purchase price for acquiring the substitute.

Full replacement cost, as referred to in part (a), is replacement cost new, in like kind and quality, undepreciated.

In the event of total loss, e.g., by fire, the insurer covers the cost of debris removal. Debris removal expense is not included in the determination of replacement cost for the purpose of applying the stated amount of insurance in the contract.

Replacement of the destroyed insured improvements does not duplicate functional obsolescence that may have existed within the original structure at the time of its destruction.

Like kind, as referred to in part (b), may be defined as referring to utility or use made of the building and its type of construction. It means the subject was a wood-frame-constructed bungalow on full basement; a two-storey masonry constructed,walk-up, office/retail building with full basement; etc. The replacement improvement then must be similar in use and construction to the insured property, or building, destroyed by fire.

Like kind, then, replictes the utility and basic construction of the insurable building improvements in present terms with regard to modern building regulations and standards as well as materials and workmanship.

Therefore, an appraiser called upon to estimate the value of building improvements for insurance purposes should consider the cost of replacing the existing improvement.

Like quality refers to the durability and performance characteristics of the particular component. This is especially true if the component is no longer produced, and a substitute is needed. However, a common error of valuers who rely upon floor area building costs from manuals produced by building cost services is that the model from the manual may be of average quality and simple design with average components, whereas the subject building improvement is of average quality, but has luxury quality heating, ventilation, air conditioning systems and a top-of-the-line, state-of-the-art roof cover.

Physical depreciation

Of the various ways to quantify physical depreciation, there is none better than careful observation.

All physical depreciation is possible to cure; however, it may not be economically feasible to cure such items as reconstruction of the building's structural carcass. Other methods, such as reinforcing a structural floor or placing cross ties to support sagging load-bearing walls, may retard such deterioration and extend the life of the building. These "cures" are usually economically feasible, whereas rebuilding the walls or floors would probably not be.

In insurance claim disputes, a carefully documented physical condition survey of the insurable improvements along with fixed building service equipment will always be accepted over straight line depreciation, mid-life theory or extended life theories, which tend to be frequently relied upon for insurance valuations by appraisers than the more time-consuming and more expensive observed condition surveys.


The inclusion of obsolescence, as described in item (c), in estimating insurable value may be a matter of underwriting policy that requires objective judgement and thoughtful, unbiased consideration of both the insurer and the insured's interests.

Economic obsolescence is a reduction in value as a result of external causes. In most cases, one could probably conclude that reduction in value caused by economic obsolescence will apply entirely to the land.

In the income approach to value, some specific factors should be addressed that may go beyond a reduction in land value as compensation for economic obsolescence. These may include abnormally high vacancy and non recoverable inducements, both of which should be stabilized for insurance claim disputes. Surely both are temporary factors in the life span of a building.

Functional obsolescence refers to outmoded features of layout or design, structural components, or fixed building service equipment, and may be incurable or curable, depending upon economic or physical feasibility.

Governing authorities having jurisdiction over the construction of the replacement building will require that it be built in accordance with modern standards as specified in local bylaws, which may include regulations such as the National Building Code. Existing functional obsolescence will not be replicated, and the restoration may also result in betterments over what the insured previously owned, at least physically or from an occupier's standpoint.

A question arises: If such windfall, cures to these obvious features of functional obsolescence do not result in realizable benefits by way of additional net revenues, has there been a betterment that should offset the insured's indemnity?

If there is no likely realizable increase in revenues from the property, or realization of such revenues is too remote, based upon Brown and Menezes' explanation of the test for betterment, there is no betterment.


Insurance law, as it applies to real estate, is derived from the whole body of that law, as it applies to personality, including marine, air and land transport, vehicle, cargos, etc., and even such things as art objects.

It is not surprising then, that a single definition of actual cash value has not become "carved in stone."

The lack of a clear definition has resulted in a plethora of vague and confusing interpretations of what actual cash value is, detrimentally affecting the parties to insurance.

One concludes that, as a general rule, where the insured intends to rebuild, then, unless otherwise defined in the insurance contract, actual cash value means replacement in like kind and quality, less physical depreciation only of the insured property.

In the event the insured decides not to rebuild, actual cash value will be interpreted as being market value of the insured property. 1


1. Swanson and Swanson v. Economical Mutual Insurance Company, (1987),77 N.B.R.(2nd) p. 372.

2. Canadian National Fire Insurance Co. v. Colonsav Hotel Co. [1923] S.C.R. 688 2 W.W.R. 1170 [1923] 3 D.L.R. 1001.

3. Insurance Law in Canada by Craig Brown, LLM. and Julio Menezes LLM. Published 1982 by the Carswell Company Limited, Toronto

4. Ibid

5. Malcolm E. Walker and Sons Ltd. v. Co-Op Fire & Casualty Co. (1966), 58 D.L.R. (2nd) 10 (N.B.C.A.)

6. Above, note 1

7. Above, note 2, p. 269.

8. The Dictionary of Real Estate Appraisal, 3rd. Edition, 1993 Published by the Appraisal Institute, Chicago, Ill.

9. Above, note 2, p. 266

10. Appraisal For Insurance Purposes, Encyclopedia of Real Estate Appraising, [1968], p. 996 Prentice Hall Inc. Englewood Cliffs, N.J.

11. Insurance Act R.S.N.B.1973 Ch.1-12

12. Above, note 11

13. Henderson v. The Minister of Tourism, (N.B.P.C.B.), 23 LCR p. 30; (N.B.C.A.), 25 LCR p. 291.

14. Above, note 7

15. Above, note 9

W Harrison Goodwin Jr., AACI BA, FRI is an appraiser with W H Goodwin & Co Ltd and Midland Estates Limited In Moncton, NB.

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