When is a property owner entitled to replacement cost coverage? What qualifies as a replacement building? This paper will provide you with what the Ontario Court of Appeal has to say on these issues, as recently addressed in its decision Carter v. Intact Insurance Co.[1].
A Primer on the Basis of Valuation in a Property Policy
Property insurance policies provide for two common basis of valuation: actual cash value and replacement cost value.
Actual cash value means the amount that a reasonable person would be prepared to pay for that property at the time of loss. Actual cash value of a property is almost always considerably lower than replacement cost because actual cash value takes into account reasonable depreciation. Most often, replacement cost coverage is available as an endorsement to a property policy for an additional premium. Actual cash value is the default. With replacement cost coverage, an insured is entitled to the full cost of repair or replacement without any deduction for depreciation.
Certain conditions need to be met in order to qualify for replacement cost coverage. These conditions can vary from policy to policy, but many include terms requiring that the “replacement” must be:
- on the same location
- effected within a reasonable time or with due dispatch; and,.
- of like kind and quality.
The Carter decision underscores the significance of the term “of like kind and quality” in the definitions of “replacement” and “replacement cost” in a property policy.
THE DECISIONS
Background and Motion Decision[2]
The plaintiffs owned a property in the City of Ottawa that consisted of a mix of one, two and three storey buildings containing 15 residential units and 13 commercial units. Collectively, the total square footage of the property, including basement and above ground, was 51,930 square feet. The property did not have underground parking or elevators and included a mix of residential and commercial tenancies.
The plaintiffs purchased property insurance from Intact, including replacement cost and building-bylaw coverage. The policy provided that “replacement includes repair, construction or reconstruction with new property of like kind and quality”.
In March 2011, the plaintiffs’ property sustained significant damages in a fire. The plaintiffs decided to demolish the remaining structures and construct an eight and a half storey condominium. The plans involved a structure totaling 193,694 square feet with underground parking, elevators and many more residential units. The building cost for the proposed condominium was estimated to be $30 million.
The parties resolved the amounts in issue by using the appraisal process pursuant to section 128 of the Insurance Act[3]. The Appraisal Award set out the following amounts:
- actual cash value: $3,900,000;
- replacement cost: $5,732,136.32; and,
- building code upgrades: $511,379.17
The plaintiffs sought compensation under the replacement cost and building by-law coverage of their policy. Intact refused to pay the replacement cost on the ground that the proposed building was not a “replacement” of the previous property. Intact proceeded to pay the actual cash value of the damaged property, leaving an amount of $2,343,515.40 in dispute.
The plaintiffs initiated a lawsuit against Intact seeking replacement cost and the amount for building code upgrades under the building by-law coverage. They brought a Rule 21 motion to determine the coverage issue in a summary manner. Before the motion judge, the plaintiffs argued that they were entitled to replacement cost no matter what they built because “replacement”, as defined in the policy, did not require that their new property be of “like kind and quality”. They relied on the word “includes” in the definition of replacement to suggest that the type of replacement is open ended and not limited to only that of “like kind and quality”. Alternatively, they argued that their proposed condominium was of “like kind and quality”. In a suitably general way, the plaintiffs were replacing a mixed-use commercial residential building with a mixed-use commercial residential building.
The motion judge rejected both arguments. He interpreted the policy to mean that replacement cost is only available if the insureds’ property is of like kind and quality. He further found that the proposed condominium was not of “like kind and quality”.
The Ontario Court of Appeal
The plaintiffs raised two issues on appeal:
-
- Did the motion judge err by holding that the proposed condominium was not a “replacement” entitling the appellants to replacement cost?
- Did the motion judge err by failing to hold that the appellants were entitled to an amount for building code upgrades?
The plaintiffs did not challenge the motion judge’s factual finding that the proposed condominium was not of like kind and quality. This finding was well supported on the record:
| Quality | Insured Property | Proposed Condominium |
| Size | 51,930 square feet | 193,694 square feet |
| Height | Mix of one, two and three storey buildings | Eight and a half stories |
| Basement area | 15,200 square feet | 32,000 square feet |
| Number of residential units | 15 | 129 |
| Parking spaces | 42 (above ground) | 165 (underground) |
| Elevators | None | Two |
A unanimous panel of the Court of Appeal agreed with the motion judge that the proposed condominium was not a replacement entitling the plaintiffs to replacement cost. The plaintiffs were entitled to actual cash value of their property only.
The plaintiffs’ application for leave to appeal to the Supreme Court of Canada was dismissed on June 1, 2017.
Underlying Principles to Guide Interpretation
To set the backdrop guiding the Court of Appeal’s interpretation of the term “replacement”, Laskin J., writing for the Court, provides a useful overview of the principle of indemnity and the concern of moral hazard:
“A main objective of property insurance is indemnity, and a policy providing for actual cash value coverage is a pure indemnity contract. Actual cash value recovery puts insureds in the position they were in before the loss. Since most property depreciates over time, actual cash value is equivalent to replacement cost less depreciation. So actual cash value recovery prevents insureds from profiting or benefiting from their loss.
But actual cash value recovery poses a problem for insureds who want to build a similar structure to replace the insured property that was damaged or destroyed. Because of depreciation, these insureds will incur a cash shortfall, which they may not be able to afford, and which will thus prevent them from reconstructing their damaged structure.
Replacement cost insurance solves this problem. It goes beyond the notion of indemnity. It recognizes that depreciation, or the deterioration of a property over time, is an insurable risk. Replacement cost insurance, in effect, insures depreciation: the difference between replacement cost and actual cash value. So, under replacement cost insurance, if insureds do indeed repair or replace their damaged property, they are entitled to recover from their insurer the full cost of the repairs or the replacement. They can replace “old” with “new”. In that sense, even though replacement cost insurance makes insureds better off and violates the indemnity principle, it is justifiable, because without it, many property owners would be unable to cover the shortfall caused by the depreciation of their damaged or destroyed property.
But, allowing insureds to replace old with new raises a concern for the insurance industry. The concern is moral hazard: the possibility that insureds will intentionally destroy their property in order to profit from their insurance; or the possibility that insureds will be careless about preventing insured losses because they will be better off financially after a loss.
To put a brake on moral hazard, insurers will typically only offer replacement cost coverage if insureds actually repair or replace their damaged or destroyed property. If they do not, they will receive only the actual cash value of their insured property. Insurers also limit replacement cost coverage to an amount defined in the insurance policy. These two conditions — insistence on actual repair or replacement and limiting replacement cost to a defined amount — are found in the appellants’ policy with Intact.”[4]
The Policy Wording
The starting point for the plaintiffs’ policy of insurance was indemnity based on the actual cash value of the lost or damaged property. The plaintiffs purchased a replacement cost endorsement to amend the basis of valuation from actual cash value to replacement cost. Replacement cost was available subject to several conditions, with the condition at issue being 1(b):
-
- The Insurer agrees to amend the Basis of Valuation from actual cash value to “replacement cost” subject to the following provisions:
(a) “replacement” shall be effected by the Insured with due diligence and dispatch,
(b) settlement on a “replacement cost” basis shall be made only when “replacement” has been effected by the Insured and in no event shall it exceed the amount actually and necessarily expended for such “replacement”,
(c) any other insurance effected by or on behalf of the Insured in respect of the insured perils under the Policy on the property to which this extension is applicable shall be on the basis of “replacement cost”,
(d) failing compliance by the Insured with any of the above provisions, settlement shall be made as if this extension had not been in effect.
[emphasis added]
The terms “replacement” and “replacement cost”, as used in 1(b), were defined within the endorsement:
-
- Definitions
(a) “replacement” includes repair, construction or re-construction with new property of like kind and quality, and
(b) “replacement cost” means whichever is the least of the cost of replacing, repairing, constructing or re-constructing the property on the same site with new property of like kind and quality and for like occupancy without deduction for depreciation.
The Replacement Must be of Like Kind and Quality
The decision, as it related to the application of replacement cost coverage, turned on the interpretation of these definitions. The Court of Appeal was satisfied that the definition of “replacement” in the policy was unambiguous and that the motion judge gave effect to its plain and ordinary meaning.
The plaintiffs argued, among other things, that the motion judge erred because he did not give effect to the word “includes” in the definition of “replacement”. The word “includes”, they argued, contemplated that the insured could choose to replace their damaged buildings by means other than repair, construction or reconstruction. The phrase “of like kind and quality”, under this interpretation, only modifies the enumerated methods of replacement: repair, construction or reconstruction, but it did not modify the unenumerated replacement, such as their condominium. The Court of Appeal did not accept the plaintiffs’ submissions, holding that a “replacement” is needed to trigger entitlement to “replacement cost”. The plain and ordinary meaning of the definition of “replacement” in the policy is that to be entitled to “replacement cost”, the replacement, no matter how it is effected, must be of like kind and quality. Laskin J. elaborated:
“…the word “includes” in the definition of “replacement” means that the replacement can be effected by a method other than repair, construction or reconstruction, for example, by purchasing an existing building to replace the one that was lost. But whatever the method of replacement, whether enumerated or not, the actual replacement must be of like kind and quality. That phrase, “of like kind and quality,” modifies or anchors all methods of replacement.“ [emphasis added]
Justice Laskin, on behalf of the panel, stated that to give effect to the plaintiffs’ interpretation of the definition of “replacement” in the contract would be either illogical, or would render the phrase “of like kind and quality” meaningless. While the plaintiffs were constructing another building, it was not a “replacement” as the term is defined in the policy because it was not a building of like kind and quality. By the plaintiffs’ own concession, the building was different and much larger.
The Court of Appeal held that this interpretation of the plaintiff’s policy also better reflects the indemnity principle. While acknowledging that replacement cost coverage does go beyond mere indemnification of an insured because it allows for a measure of betterment, allowing replacement cost only where the replacement is of like kind and quality to the damaged or destroyed property gives the insureds enough money to rebuild something equivalent to the property that was damaged or destroyed.
Although this finding was enough to dispose of the first issue on appeal, for completeness, Laskin J. proceeded to address the arguments based on the application of Chemainus Properties Ltd. v. Continental Insurance Co.[5].
The Chemainus Decision
Historically, there is little guidance in the case law considering the phrase “of like kind and quality” within the context of interpreting replacement cost coverage. The plaintiffs cited the 1990 British Columbia Supreme Court decision of Chemainus Properties Ltd. v. Continental Insurance Co. as being consistent with their position that the proposed building was a replacement entitling them to replacement cost coverage – essentially, that it was not required to be “of like kind and quality”. While the replacement provision was similar, but not identical, in Chemainus, the argument advanced by the property owner and accepted by the trial judge in Chemainus was identical to the argument advanced by the plaintiffs in Carter.
The trial judge in Chemainus held that the replacement provision in the policy was not a definition and therefore, there was no requirement for a replacement building to be constructed with materials of like kind and quality. The Court of Appeal in Carter disagreed with the trial judge’s interpretation of the policy and commented that the interpretation was at odds with the plain and ordinary meaning of the definition of “replacement” in the policy. Further, Laskin J. did not “feel bound to follow a trial decision, which was given a quarter of a century ago and has never received appellate approval”[6].
The Building Code Upgrades
The second issue on appeal was disposed of for similar reasons to the first. The wording of the building by-law endorsement permitting entitlement to an amount for building code upgrades paralleled entitlement to replacement cost. The building bylaw endorsement was not triggered because the condominium was not of like height, floor area, style or occupancy to the plaintiffs’ insured property.
The plaintiffs were therefore not entitled to building code upgrades for their condominium.
PRACICAL IMPLICATIONS – WHAT IS SUFFICIENTLY SIMILAR?
In practice, insurers have generally permitted some deviation between the replacement property and the damaged or destroyed property when indemnifying an insured on a replacement cost basis. In our view, the Carter decision does not herald an end to this practice, but may be viewed as tightening the reins on the permissible amount of deviation.
Going forward, we are unlikely to see the practice of permitting replacement cost coverage with use of the proceeds toward the building of something substantially different. However, the Carter decision should not be interpreted as requiring the replacement to be an exact replica of the damaged property.
Recall that in the appeal, it was conceded that the proposed replacement building was not of like kind and quality to the original structure. The Court of Appeal has made clear that a replacement building needs to be of like kind and quality. In the future, we can expect that the real discussion will focus of what is sufficiently similar to trigger replacement cost coverage. The question becomes, then, what is a permissible level of deviation?
The Superior Court in Carter provided some guidance in this respect. Justice Phillips references obiter dicta comments made by Justice Coultas in the Chemainus decision[7]:
“Like kind and quality does not imply that every truss, or siding, or finish, or style of the building, for example must be identical. That would be absurd considering that 20 years separates the dates of their construction, and construction methods and aesthetic tastes change.”
Justice Phillips acknowledged that there could be changes necessitated by developments in building practice or styles over time. He aptly describes the ultimate decision as a judgment call.
There is no hard and fast rule as to when a property will be considered sufficiently similar to attract replacement cost coverage. This should be assessed on a case by case basis keeping in mind the indemnity principle and purpose of replacement cost coverage along with the notion that the potential for betterment is more difficult to control if a replacement is not similar enough.
As a practice consideration, where an insured carries replacement cost coverage and demonstrates an intent to rebuild or replace the building, an insurer may wish to bring to the insured’s attention the replacement cost wording in the policy. While provision of the policy to an insured may will satisfy an insurer’s good faith obligation to provide information, dialogue with the insured, particularly where there is knowledge by the insurer on the type of proposed replacement, may prevent future litigation and allegations of bad faith.
[1] 2016 ONCA 917 (“Carter”)
[2] Carter v. Intact Insurance Co. 2015 ONSC 4400
[3] R.S.O. 1990 c. I.8.
[4] Carter t paras. 21-25.
[5] [1990] B.C.J. No. 154 (“Chemainus”).
[6] Carter at para 52.
[7] Carter v. Intact Insurance Company, 2015 ONSC 4400, at para.35.
