Why is it that the amount an insurance carrier pays out to settle a business income/inventory/contents/property claim is many times far greater than the amount recovered in a subrogation suit against the party, given liability? Why does this gap often exist in the first place, which could total millions of dollars depending on the size of the loss, and what, if anything, can be done to close it?
The simple answer lies within the venue; the immediate first party claim is paid pursuant to a contract – the insurance policy, with specific inclusions, exclusions, coverage limits, time period and valuation methods. The subrogation suit, filed to recover the amounts paid in the first party action, is brought pursuant to state law, where different methods of determining damages are required. The insurance company will typically (and understandably) try to recover all the amounts they paid to the insured; however, they have to apply different damage valuation formulas to the components of the claim to make their recovery under state law. The difference between damages determined according to the insurance policy and state law can be significant.
Let’s look at a typical case. A flood after a tropical rain storm severely damages an office building complex resulting in building, contents, equipment, valuable papers and inventory losses for a business, including significant lost business income and extra expenses totaling over $5 million. The insurance company responds immediately by hiring a variety of experts and adjusting the loss according to the terms of the policy, which requires replacement cost values for all property and equipment. The defense hires its own damages experts and finds most of the property was old and outdated and come up with a $3 million loss amount, a $2 million difference. How could this happen? The general answer is that the equipment and property damaged was old and depreciated with a lower fair market value (FMV) and the insured received replacement cost values for the items lost – although there are likely many more details to explore.
Foresight vs. hindsight explains one reason for the difference between a first party and third party claim. The experts hired by the defense have the benefit of time and hindsight in making their damage calculations, whereas adjusters and other experts in a first party claim are making projections and dealing with the immediacy of the loss. Third party experts have the time to calculate the actual costs to rebuild or replace destroyed property since the subrogation suit is usually in discovery several years after the event. The carrier on the other hand, must pay the claim quickly on the basis of estimates and proposals since time is of the essence. The difference between cost estimates and actual costs are often significant. But most importantly, the valuation methods are different between what the policy will pay and what is allowed under state law.
Jim Stavros, CPA is a consultant with DJS Associates, Inc. Mr. Stavros’ practice involves assessing all types of damages in subrogation and other matters, including lost profits, personal injury/wrongful death, fraud, business disputes and other related matters.