Narrowing the Gap

Subrogation Damages—DoYour Homework

by James A. Stavros

The amount an insurance carrier pays out to settle a claim is usu-ally far greater than the amount recovered in a subrogation suitagainst the party considered liable for the loss. Why does this gapoften exist in the first place and what, if anything, can be done toclose it?

© 2004 DRI. All rights reserved.

August 2004 21

The simple answer lies within the venue;the immediate first-party claim is paid pur-suant to a contract—the insurance policy,with specific inclusions, exclusions, coveragelimits, time period and valuation methods.The subrogation suit, filed to recover theamounts paid in the first-party action, isadjudicated pursuant to state law, where dif-ferent methods of determining damages arerequired. Therefore, the insurance companywill try to recover all the amounts they paidto the insured, but will have to apply a differ-ent valuation formula to the components ofthe claim to make their recovery. The differ-ence between damages determined accord-ing to the insurance policy and state lawcan be significant.

Consider a simple but typical case. A di-sastrous fire at a manufacturing plant de-stroys the building, contents, equipment andinventory. The total loss including lost busi-ness income and extra expenses totals sev-eral million dollars. The insurance companyresponds immediately by hiring a variety ofexperts and adjusting the loss according tothe terms of the policy. The carrier pays the$5 million claim and files a subrogation suitin state court against the building contractorwhose liability they believe is clear. The de-fense hires its own damages experts and thecourt awards the plaintiff only $3 million.

The first fact to be faced by the carrier isthat the methods for valuing inventory, prop-erty damage, business interruption and otherelements of the loss for policy purposes varyfrom those recognized by the courts of thedifferent states. The second fact is that theexperts hired by the defense have the benefit

of time and hindsight in making their calcu-lations. These experts have the time to cal-culate the actual costs to rebuild or replacedestroyed property because the subrogationsuit is usually in discovery several years afterthe event. The carrier, on the other hand,must pay the claim quickly on the basis ofestimates and proposals since time is of theessence. The difference between estimatesand actual costs are often significant. Butmost importantly, the valuation methodsare different between what the policy willpay and what is allowed under state law.

The following sections highlight somekey issues, valuation points and pitfalls indetermining money damages in subroga-tion suits. By proactively addressing manyof the points listed below, the parties bring-ing the subrogation suit will have a moresustainable and credible damage estimate.

Subrogation ActionThe work on the subrogation file begins onthe day the loss occurs. Most claims fromcarriers come in two forms: straight subro-gation to recover the amount paid out tohonor the policy, and an additional claim bythe insured to recover the difference betweenthe amount received and any residual re-placement costs. Since the entire claim istypically brought in the name of the insured,the carrier becomes the subrogee of the in-sured. The claim by the insured thus needsto be identified separately from the claimby the subrogee carrier. The latter actionhappens frequently when the insured:• Is underinsured or uninsured;• Has a high deductible;• Has a high co-insurance clause;• Was not happy with the claim settlement;• Has a valuation method in the policy

which does not reflect the true value ofthe loss; and

• Has a loss greater than the policy termlimit (typically one year).

Preparing for theSubrogation CaseThe use by the subrogee of the same expertreports employed in the first-party claimmay save some money, but is usually a mis-take. As noted above, the claim as quantifiedin the insurer’s expert reports uses formulascontained in the insurance policy that arenot necessarily the same as those contained inthe state law. The application of these diverseformulas for losses to buildings, equipment,machinery, contents and even inventory canproduce results that vary by millions of dol-lars. If these variations are not proactivelyidentified and adjusted, the subrogee plain-tiffs risk an embarrassing examination by thedefense. Failure to address these discrepan-cies may also impair the credibility of cal-culations in other areas of the plaintiff ’sdamages claim.

Correct methodology and sufficient docu-mentary support are the two key elementsneeded to develop a sustainable proof ofdamages. In the first-party claim, expertsfrequently rely on estimates to value recon-struction, loss of contents, business inter-ruption and extra expense. The insurancecompany bases its decision to pay the claimon these estimates, among many other fac-tors. In many cases, estimates and propos-als are used to save time during the periodof emergency or reconstruction but are notsufficient to provide proof in the subrogationaction. Proof of actual damages or loss is re-quired under state law. Only actual invoicesand copies of cancelled checks evidencingthe cost of items will be accepted as evi-dence. Failure to produce these documentsraises doubts as to whether the insured actu-ally sustained the loss claimed. Simply put,an estimate of the cost to rebuild a buildingis not sufficient proof when actual invoicesand payment data are available.

Building ClaimsBuilding claims are probably the biggestloss item in a catastrophic claim. Based onthe age and condition of the building, thedifference between the insurance paymentsat the replacement cost and the fair marketvalue (FMV) at the time of the accident canbe significant. For example, a recent caseinvolved the partial destruction by fire of an

James A. Stavros, CPA, is a principal in Kroll’s forensic accounting and liti-gation consulting practice in Philadelphia. Mr. Stavros’ practice involvesassessing all types of damages in subrogation and other matters, includ-ing lost profits, personal injury/wrongful death, fraud, business disputesand other related matters.

22 For The Defense

An estimate of the cost

to rebuild a building is

not sufficient proof.

old restaurant completely renovated in the1950s with the original structure dating backalmost 100 years. The capital improvementbudget indicated the rugs, tables and roomswere old and outdated and the restaurantwas not in compliance with local safety andbuilding codes. The claim, including calcu-lations for the building, stored equipment,inventory, contents, extra expenses and abusiness income loss, exceeded $5 million.The building and contents portion of theclaim were paid based on estimated valuesfor replacement costs and building codeimprovements according to formulas in thepolicy and not on the actual expendituresby the insured.

When the matter was subrogated, sev-eral problems arose. Since the restaurantwas in Pennsylvania, the allowable methodof valuing property damages under Penn-sylvania law was to apply the lesser of therepair/replacement costs or the decrease infair market value of the property caused bythe destruction. The first-party claim forreconstruction had included significant bet-terments. The dining room, kitchen, bar andother areas had been expanded and improvedat a cost the insured sought to recover insubrogation. A claim was made by both theinsured (for a far greater sum) and the car-rier. Construction experts and forensic ac-countants were needed to calculate damages.The construction expert provided a valua-tion for the construction needed to restorethe restaurant to its former state. This figurewas a several million-dollar difference be-low the amount claimed by both the carrierand the insured. In this case, the actual pay-ment documentation for the building wasnot a good measure of damages becausesignificant changes and betterments weremade to the building. The insured was notput back to their pre-fire condition of anolder and somewhat outdated facility. Anappraiser was retained to provide an FMVopinion to the contents claimed (i.e., tables,chairs, rugs, etc.), which resulted in an amountseveral hundred thousand dollars less thanwas claimed. Some of the documents andissues to be considered in evaluating prop-erty loss include:• Historical cost and maintenance;• Original and reconstruction blueprints,

diagrams and layouts;• Insurance appraisals or other estimates

of fair market value;• Age of items;• Usage and remaining useful life;• Accuracy, reliability and condition of ac-

counting and business recordings docu-menting the items claimed;

• Capital expenditure budgets and history;• Construction records including engi-

neering document contracts; and

• Actual invoices and proofs of payment.If the insured has expanded or improved

the building or the money paid by the carrierfor one purpose was used for another, thedefense will likely argue that the insured isentitled to be made whole and nothing more.For example, the destruction of an old build-ing and its aged contents may be compen-sated for on the basis of replacement coststhat may actually improve the position of theinsured, who now has a new building andcontents. Under typical state law, the insuredwould be entitled to have back only the oldbuilding and aged contents or a similar proxy.

Equipment ClaimsEquipment claims are valued in a mannersimilar to building or contents claims. Main-tenance logs, accounting usage and historicalinformation are usually kept for large piecesof equipment. These documents must beanalyzed to help determine the conditionand useful life of the equipment before arriv-ing at the FMV. For older and very special-ized machinery, there is often a big differencebetween the FMV, the actual cash value (ACV)and the cost of repairs. ACV has been de-fined by most carriers to be the replacementcost of an item reduced by some deprecia-tion factor. In one noted case, approximately$800,000 was paid based on repair estimatesfor very specialized glassmaking machinesthat were sitting unused in a warehouse whenthe roof collapsed on the building. The ma-chines were damaged but not destroyed. In

the subrogation, the reason for the machin-ery being offline was investigated, and themaintenance and accounting records wereexamined for each machine. The companyhad decommissioned some of the equip-ment due to obsolescence and written downthe values in their accounting records. Anequipment appraisal expert opined that thedecrease in FMV for some of the pieces wasless than the repair estimate. In addition,the company did not repair some of the ma-chines and apparently used the money paidby the carrier for other purposes. The anal-ysis of estimated repair costs, actual repaircosts and FMV all indicated a substantiallylower value for the equipment loss than the$800,000 claimed.

In another case, a carrier paid a $700,000claim to repair some moderate damage toold, secondhand milling machines basedon a proposal. An appraisal of the machinescompleted in the five months prior to thefire for the purpose of selling the companyhad indicated their FMV to be approximately$250,000. Accordingly, even on the assump-tion of a total loss, this claim should havebeen limited to the FMV. The company’sactual repair invoices indicated they hadnot been repaired as claimed. In fact, littleif any repair had been performed and nodocuments were ever provided to supportthe $700,000 repair claim. This omissionraised the question of whether the repairsas claimed were necessary or valid.

Business InterruptionFirst-party business interruption losses aretypically paid partly on estimates where theperiod of loss and the quantum of lost salesare projected into the future. Many times, theperiod of loss is dictated by the policy limitor by the period required for building recon-struction. In a subrogation matter, however,the accounting expert can look back at theactual results. Nevertheless, expected salesabsent the incident still need to be projected.The expert must determine whether the ac-tual loss period was the same as the oneclaimed. The expert must also examine thebooks and records, perform independentresearch as appropriate and be careful to sepa-rate extra expense costs from the insured’saccounting records.

August 2004 23

One should never assume that the decreasein sales and profits and increase in costs aresolely attributable to the loss event, unless itis a total loss. Several other factors unrelatedto the loss event, such as the timely entry ofa substantial competitor, a rise or fall of costsof key materials, a labor strike or a pre-incident decreasing sales trend could haveimpacted the company. For instance, anysales decline must be carefully analyzed todistinguish that part attributable solely tothe loss event. The insured may initially at-tribute the whole decline to the loss event.The appropriate valuation method to deter-mine business income losses is lost profitsand not lost sales. Both sales and costs needto be projected and analyzed to measure lostprofits. In addition, “saved expenses,” or coststhat would have been incurred but for theincident, also need to be quantified and fac-tored into the loss model.

Extra expenses are generally defined asexpenses incurred to reduce the amount ofbusiness income loss. These expenses mustbe checked to see if they, in fact, exist and arerelevant to the claim. Insureds often mis-takenly commingle extra expenses and op-erating expenses on their books with theresult that net income for the loss period isdistorted. Since extra expenses are beingseparately quantified and paid, they shouldnot be included in the income statement. Ifextra expenses are included as an expense onthe income statement, they will be recordedas having been paid twice: once from theseparate extra expense account and oncefrom income. Therefore, it is very importantto determine how extra expenses are beingrecorded in the financial statements of theinsured and to isolate operating expenses inthe income statement.

Inventory ClaimThe difference in valuation methods be-tween the insurance policy and state law canbe startling in the area of inventory losses.Establishing the very existence of the inven-tory can be a problem following catastrophicdestruction. Proof that the quantities andqualities of lost inventory listed in the claimactually existed can be hard to establish, es-pecially if the destroyed inventory cannotbe counted. In the absence of the goods them-

selves, perpetual inventory, shipping, receiv-ing and historical physical counts reportsneed to be utilized.

The process of valuing inventory is com-plicated by the fact that inventory can exist invarious forms such as raw materials, work inprocess (WIP) and finished goods. Each in-ventory type has different valued compo-nents. Both WIP and finished goods containlabor and materials costs as well as companyoverhead; raw materials, on the other hand,typically have only their acquisition cost.Inventory is recorded on the balance sheet atactual or standard cost. Destroyed finishedgoods inventory, however, are typically val-ued at sale price less selling costs for mostinsurance claims. Thus, the method of valu-ing different classes of inventory is uniformfor accounting purposes (i.e., at cost), butdifferent for the insurance claim. In subro-gation, since inventory is property, inven-tory loss is likely to be valued at the lesser ofthe repair/replacement cost or the decreasein FMV for all inventory. Therefore, finishedgoods inventory would not be valued at saleprice, but more likely at actual cost. The dif-ference between valuing finished goods atsale price or cost can be significant and de-pends largely on the company markup orgross profit.

A careful analysis of the quantity lost thatincludes shrinkage, accounting adjustmentsand obsolescence also needs to be made.

These items are not always addressed in thefirst-party claim and require access to thecompany’s accounting records and possiblyto those of the outside auditor as well. Shrink-age adjustments record the difference betweenbook and physical existence of inventoryand can act as a check on the accuracy ofperpetual inventory as of the date of theloss. If perpetual inventory records have notrecently (or perhaps ever) been checkedagainst physical counts, it is difficult to deter-mine the actual loss when destruction hasbeen total. A perpetual inventory system isone that is constantly updated for shipmentsin and out so that the total quantity of theinventory is known on any one day.

Obsolescence refers to the relative fairmarket value of inventory based on techno-logical change, decline in demand, age, use-ful life, etc. of the asset. Some companiesargue that obsolete inventory still has somevalue and are reluctant to record a write-downand expense adjustment on the income state-ment. Destroyed obsolete inventory shouldbe valued on the basis of FMV, which maybe less than historical cost. If the carrier paysa claim for the entire inventory at cost or re-placement value, the insured may have beenovercompensated.

Unfortunately, obsolescence is often notaddressed at the beginning of the valuationand frequently becomes a significant part ofthe claim only after later examination. For

Category Policy Valuation Typical State Law Valuation

Building Replacement cost, repair cost orActual Cost Value, estimates

Lesser of repair, replacement ordecrease in FMV, actual costs

Equipment Replacement cost, repair cost orActual Cost Value, estimates

Lesser of repair, replacement ordecrease in FMV, actual costs

Contents Replacement, historical cost, repaircost, Actual Cash Value, estimates

Lesser of repair, replacement ordecrease in FMV, actual costs

Inventory Replacement cost, historical cost,sales value

Lesser of repair, replacement ordecrease in FMV

Business Future estimates, some actualresults, policy limit at 12 months

Hindsight, actual results, focus onvarious reasons for sales decline

(Note: Each state law should be reviewed to determine the specific valuationmethod. Calculation of damages and application of state law is primarily basedon experience in Pennsylvania.)

24 For The Defense

Obsolescence is often

not addressed at the

beginning of the

valuation.

example, a fire at a stationery warehouse de-stroyed paper rolls and envelopes that wereseven years old and considered obsolete byan industry expert. The reduced value ofthe obsolete stock and the low replacementcosts resulting from a decline in paper pricesforced the insured to reduce its claim bytwo-thirds.

The table on the preceding page showsthe different valuation methods used by atypical insurance policy and contained in atypical state law

Other Important Claim IssuesClaimed damages need to be proven andproof requires adequate support. Incredibly,some carriers choose to pay the claim evenwithout this evidence; others pay simply tomaintain customer satisfaction. This posi-tion or philosophy can cause problems laterwhen a subrogation suit is filed against athird party and the inadequacy of unsup-ported estimates to establish damages be-comes obvious. However, many payments aremade on the overall premise that if the insuredcan receive money quickly, a business inter-ruption period will be reduced, thereby sav-ing the insured (and carrier) money.

The insured will submit a claim for theirentire loss whether or not they are fully cov-ered by insurance. Carrier payments will berestricted by policy time limits, coverage,dollar and co-insurance limits before anydocumentation is reviewed. Essentially, thisrelates to coverage issues. Then, the carrierwill further reduce the total amount paid byadjusting the loss for documentation, appro-priateness and the application of suitablevaluation formulas to each claim compo-nent. After the carrier makes their variousadjustments and pays the claim, and subro-gation action begins, the insured may alsofile a claim for the amount that was not paid,or the amounts that were “adjusted” out. Inthese instances the subrogation action is, ineffect, two claims: one by the carrier andanother one by the insured. Special atten-tion must be paid to the support providedfor the individual damage elements in eachclaim. The reasons why the company wasnot fully insured should also be examined.

One of the benefits of the subrogationprocess is that it permits 20/20 hindsight.

Projections and estimates based on insuffi-cient evidence can be eliminated. The realvalue of losses can be more accurately cal-culated. In addition, the appropriatenessand reasonableness of decisions by both thecarrier and the insured can be better as-sessed. For example, the decision to incurcertain costs or enter into agreements that donot represent market rates or industry ac-ceptable standards can be questioned. In onerecent case, the reconstruction of a ware-

tents and inventory of a large contractor, theclaim filed showed he was severely underin-sured. After the claim was paid, the contrac-tor sued his insurance agent for amountsnot covered by insurance and the carriersubrogated against various third parties.Analysis of numerous invoices for destroyedinventory submitted to support the claim aspaid as well as the contractor’s additionalclaim showed dates altered or forged. Theseinvoices were submitted to the carrier tosupport the inventory claim and were paid.Comparison of the inventory listed on thebalance sheet near the time of the loss withthe amount claimed to have been in thebuilding revealed a large difference. As a re-sult of discovering this fraud in the inventoryclaim, the contractor’s entire claim was im-paired.

ConclusionIn the end, it is impossible to close the gapcompletely between the amount paid outunder a policy and the amount awarded bythe various state courts in subrogation cases.The different valuation methods employedto meet the terms of the policy and the re-quirements of the courts will still producetwo different results. Nevertheless, some nar-rowing of the gap is possible with the use ofmore complete and accurate documenta-tion and hindsight. Hindsight, as it applies todecisions made, costs incurred and actualversus estimated or projected costs and sales,can have a substantial impact on the quan-tity of loss amounts determined. Since timeis not always of the essence in a subrogationclaim, more attention can be focused on is-sues not always fully addressed in the first-party claim. Obsolescence of inventory, thefinancial condition of the company, com-pleteness of documentation and a compari-son of the “projected” and “estimated” salesand costs to the actual sales and costs in-curred subsequent to the loss event can allbe closely analyzed in the subrogation mat-ter and are frequently omitted in the first-party claim.

Both the plaintiff and defense must dotheir homework in quantifying damages insubrogation matters in order to avoid thepitfalls that can damage credibility andnegatively impact their claim.

house resulted in net profit and overheadcharges in aggregate approximating 65 per-cent of the total costs of the project by vari-ous contractors. This combined markup ratewas clearly far above the industry standardfor reconstruction and represented excessivemarkups that should not have been passedon to others to pay.

FraudA desire to defraud the insurance companyis a recognized risk and is always investi-gated when arson is suspected. The finan-cial condition of the insured and the level ofinsurance coverage should be investigatedeven when criminal intent is not suspected.Insureds in financial distress or who areunderinsured are more likely to submit overlyaggressive claims and even commit fraud.False or altered invoices, overly aggressivesales forecasts, non-existent contents orinventory, false or unrealistic estimates forreconstruction or repair are always a pos-sibility in any claim. The instinct for cor-porate financial survival is strong and acatastrophic loss may tempt honest but fi-nancially distressed owners to file an in-flated claim. The financial expert needs tobe aware of these possibilities and be readyto ask the right questions and request theright documents.

For example, when a roof collapse dam-aged a building and caused the loss of con-