Dissertation prepared by Alan FitzGerald addressing the legitimacy of arbitrary retentions under Property Policies.
RETENTIONS – Are Insurers entitled to hold back money on agreed claims on a general percentage or arbitrary basis? Alan FitzGerald, Chartered Loss Adjuster and Fellow of the Chartered Insurance Institute suggests they are not.
Over the past five years the majority of insurance companies in the Republic of Ireland have introduced what I refer to as “arbitrary” retentions. In simple terms if a settlement is €10,000 they hold back 30%, paying €7,000 now with the balance of €3,000 to be paid when the works are done and invoices submitted. It is my view that this is a fundamental error in the understanding or interpretation of how an indemnity under a material damage or property Policy is calculated and applied. In simple terms if a Policyholder’s kitchen is destroyed and it costs €10,000 to replace, if she receives €7,000 but chooses not to replace it then she has not been indemnified. She should get €10,000 less wear and tear deductions which in the event that the kitchen will not be replaced in her lifetime would be, nil whereas under the “arbitrary” approach she is left with a shortfall of €3,000 which represents an unjust enrichment for Insurers. In essence what has happened is that Adjusters and Insurers have “imported” the provisions of the Reinstatement Memorandum as applicable under Commercial Policies and applied it across the board to both “valued” and “unvalued” Policies. Each Policy wording should be interpreted individually and when it comes to Personal Lines Policies the wordings do not vary to any great extent except where there is reference to costs being incurred etc. and I will deal with this later in this article. However at this point let us look at the background to the origin of retentions and how matters have developed in this country and indeed how practice has departed completely from that existing in the U.K. and Northern Ireland.
The whole premise of indemnifying a Policyholder is to put them in the same position after the loss as they were before and there is no provision for delaying this process or, in the absence of a specific policy wording, adding conditions to its release. The function of a material damage Policy is to pay a sum of money so the Insured is placed in the same financial position after the loss as he was before.
Clearly there is an element of confusion in the context of “reinstatement” and indemnity. It is worthwhile getting a historical perspective and in this respect in the 1920’s representations from textile and metal concerns in British Industry forced Insurers to accept that normal material damage claim settlements i.e. repair or replacement less deductions for wear and tear dictated that Policyholders had not enough money to make up the difference between the “traditional indemnity valuation” and the cost of replacing machinery. In other words there was a shortfall in what was available from Insurers and what it cost to replace or repair machinery.
In recognition of this the insurance industry responded with the Reinstatement Memorandum which in essence makes the Policy a valued Policy in that it defines the basis of value for indemnity, no different from marine valued Policies.
Following initial scepticism the Reinstatement Memorandum became well established for buildings and plant and machinery. It applies to Commercial Policies only. There are specific procedures to be followed, in essence that the works have to be carried out. If the works are not carried out then settlement is calculated on a reinstatement less wear and tear basis i.e. “traditional indemnity” basis. The contract does not “revert” to indemnity, it simply reverts to the form of indemnity that would be within the basic Policy cover i.e. the Insurer agrees to pay the value of the property at the time of the happening of its destruction or the amount of such damage etc. The Reinstatement Memorandum has other features such as an acceptance of a measure of under-insurance before penalising the Insured i.e. average will not apply if under-insurance is less than 15%.
As stated the Reinstatement Memorandum is relevant to Commercial Policies only. However there seems to be confusion amongst Insurers and indeed Adjusters in relation to unvalued policies for example Personal Lines or Household Policies particularly in the context of “reinstatement” and “indemnity”. It must be remembered that all policies are policies of indemnity although the method of indemnity can be modified to become new for old or in the case of buildings, reinstatement. For the purpose of this argument let us take it that new for old and reinstatement are the same thing.
In other words if I lose something I get something new to replace it or if its damaged I get money to reinstate or repair it to a condition equal to but not better than it was prior to the damage. There are three particular scenarios where the Policyholder is not entitled to this cost.
The first is where the sum insured is inadequate and the Policy specifically makes reference to under-insurance or a deduction for wear and tear. Secondly where the building is not maintained in a good condition or state of repair again deductions are made for wear and tear. The third is the Policyholder decides that reinstatement is not appropriate for whatever reason, that being the case the method of settlement will no longer be the reinstatement cost but to put the Policyholder back in the same financial position – a different form of calculation has to be made. Market value is one but this is relevant in very limited circumstances only.
In essence if a Policyholder is not going to carry out reinstatement works i.e. repairs of damaged plasterwork or indeed rebuilding of a complete property (setting aside for purposes of this argument market value) then they are entitled to a “traditional indemnity” calculation. This is the reinstatement cost less wear and tear deductions on a component basis and this is the loss which the Policy undertakes to indemnify.
For example if a property is due to be decorated every ten years and damage occurs in the fifth year then the scientific deduction for reinstatement less wear and tear is 50% of the redecoration costs. This should be done on a component basis for example doors, skirting, plasterwork. However, clearly doors, skirting, plasterwork will be there for the entirety of the Policyholder’s lifetime so that the deductions should be nominal if not “nil”. If a property is in poor condition then the deductions might exceed 30% or indeed 50% but the calculation still needs to be done. On average the deduction should rarely exceed 10% (particularly for Household Policies).
Historically the procedure has been quite different for Personal Lines and Commercial Policies. What is referred to as a “retention” was invariably applied where the Reinstatement Memorandum applied to Commercial Policies pending reinstatement and once the reinstatement cost was calculated, an initial payment was made based on the “traditional indemnity” calculation i.e. reinstatement less wear and tear and the balance was referred to as the “reinstatement difference” or reinstatement retention. This concept is referred to in the CILA Publication “The Principle of Indemnity and its application” and the author, RM Walmsley, deals with it in the context of a claim agreed under the Reinstatement Memorandum. The Memorandum has a proviso that the cost of reinstatement has to be incurred and he states that the Insured can “legitimately call for the payment of an indemnity other than on the basis of the Reinstatement Memorandum” and he gives the example of an old building not in good repair and that if the “traditional indemnity is calculated, a deduction of say 50% might be made for wear and tear in order to establish the indemnity”. Otherwise he suggests that Insurers are often called upon to make an initial payment on this “traditional indemnity” calculation and he suggests “only nominal sums are withheld and these are described as the reinstatement difference”. I think this undermines the proper approach in that the procedure is to make deductions on a scientific basis i.e. each component part addressed and deductions calculated and there should be no difficulty with this.
Personal Lines Claims had been dealt with on a replacement or reinstatement or new for old basis with, on balance, no deductions but circa five years ago in the Republic of Ireland one or two Insurers started to introduce retentions across the board on Personal Lines claims and these started initially at a low level at circa 10% but have since “crept” up to 30% and there is a suggestion that some Insurers are considering further increases. These retentions are clearly arbitrary on the basis they are applied across the board without individual consideration for each case. This approach clearly comes from that applicable to the Reinstatement Memorandum but is inappropriate for “unvalued” Policies where this wording does not apply and furthermore the use of arbitrary figures is fundamentally flawed.
Notwithstanding this Insurers’ attitude would appear to be that they will simply pay the balance when the works are done but, as outlined the procedure constitutes a fundamental disregard of the principle of Indemnity and indeed its application. Insurers appear to be justified in their position in suggesting that the majority of retentions are not pursued (thus saving Insurers millions). This is missing the point and indeed is due to a number of reasons including the fact that the Policyholder is not given sufficient funds initially to complete the works and inevitably cash deals are done so that invoices cannot be produced in any event. In essence it is a “catch 22” situation for the Policyholder which indirectly encourages Policyholders to operate in the “black” economy. It must be remembered that the function of a Material Damage Policy (as enshrined by the Marine Insurance Act 1906) is to pay a sum of money to the Insured so that he is placed in the same financial position after the loss as was enjoyed before. The loss is measured in monetary terms and depriving the Insured of his full monetary entitlement in essence alters or amends the terms and conditions of the Policy in favour of the Insurer. The loss is measured in monetary terms and legal precedent dictates that this is a well established approach and possibly with the exception of the Reinstatement Memorandum or indeed where “incurred” is specifically referenced in the Policy then Insurers are acting outside the terms and conditions of the contract and arguably on an illegal basis. However when there is a retention under the Reinstatement Memorandum or where “incurred” etc. is noted, Insurers still have to calculate the retention in the context of the “traditional indemnity” approach.
It is worthwhile reviewing various Policy wordings and looking at Personal Lines or Household Policies, they invariably state that deductions will only be made for wear and tear and depreciation if the sum insured is inadequate or that the buildings are not in a good state of repair. The implication therefore is that retaining monies under these types of wordings is prima facie evidence of breach of contract. Some Household Policies might have reference to claims being settled on a “new for old basis” provided repair or replacement is carried out without delay. Clearly in that situation Insurers are entitled to retain the reinstatement or “new for old” cost or difference until reinstatement has been carried out without undue delay. But again there is no provision for the retention of an arbitrary figure in the context of this wording. Whilst each Policy wording should be looked at, the basic tenet is the same i.e. there is no provision for retaining figures in excess of 20% or 30%. Where Policy wordings stipulate deductions for wear and tear, only for an inadequate sum insured or where the building is not in a good state of repair then the argument is that no retention whatsoever should be made. However clearly where there is a third criteria, in other words where repair or replacement must be carried out, then Insurers are entitled to hold back the reinstatement difference or correctly calculated retention and to reiterate this will invariably apply under Commercial Policies where the Reinstatement Memorandum is applicable.
It is of interest to note that where under-insurance applies under the Reinstatement Memorandum and the loss is adjusted for “Average”, Adjusters do not apply a retention to the adjusted figure. This is on the basis that they accept that the adjusted loss is no longer a reinstatement calculation but an “indemnity” calculation in respect of which the reinstatement retention does not apply. Notwithstanding the misuse of retentions under “Unvalued” Policies, Adjusters still follow the same approach, in other words, do not apply retentions where there is under-insurance. You can therefore have the ridiculous situation where the nett loss after under-insurance is more than that after application of an arbitrary retention before average which further exposes the improper and inequitable nature of arbitrary retentions.
A recent development is the scrutiny of invoices notwithstanding the fact work has been completed and inspected. Some Loss Adjusters are now looking for detailed breakdowns of invoices. Aside from the fact that Policyholders are not obliged to submit invoices, they do constitute prima facie evidence of completed works and unless there is some irregularity in terms of VAT etc. then they should be accepted as reasonable proof of completed works as a Policyholder is not obliged to provide absolute proof. Some Insurers are putting time limits on retentions which again have no validity on the basis that the retention is outside the terms and conditions of the Policy so conceivably Insurers have to leave their file open indefinitely as Policyholders are within their right to revert for payment of their “full indemnity” in the absence of terms and conditions stipulating otherwise. This has obvious implications for Insurers in terms of historical cases.
To avoid criticism I think Insurers need to urgently review their approach. If Insurers are insisting on maintaining retentions it should be done in accordance with Policy cover and on a proper scientific basis with the retention aspect to be calculated on an item or component by component basis so that if the Policyholder decides not to carry out the works or indeed does the work and does not submit proof of expenditure, that they receive a full and complete indemnity and not a settlement that has been incorrectly calculated or indeed a settlement or indemnity that has been delayed in the event that full proof or invoices are submitted subsequently. In essence when a claim has been agreed or adjusted and maintenance of a retention is relevant, two options should be provided to the Policyholder. The first is the reinstatement cost i.e. without deductions for wear and tear (€10,000 in our opening example) and the second is the “traditional indemnity” settlement which is reinstatement less accurate wear and tear deductions and which should be paid immediately say (€9,500 in our opening example). The balance or difference between both (i.e. €500) is the “reinstatement difference” and can be released when invoices are submitted. But as stated previously this approach will only apply where the Reinstatement Memorandum applies or there is reference to “incurred” or “works carried out” in the Policy. In the vast majority of cases the deductions will be nominal or indeed “Nil”.
Recent judgements have highlighted occasions where Insurers were in breach of their duty of utmost good faith to Policyholders and this duty is further underpinned by the advent of the Consumer Protection Code. The issue of “arbitrary” retentions has been brought, on a general basis, to the attention of the Financial Services Ombudsman’s office and indeed the Central Bank but no individual case has been dealt with to date. If Insurers want to avoid criticism or indeed expensive retrospective action then they need to deal with each individual case in accordance with legal precedent and acknowledged procedure. Policy wordings utilised in this country are invariably based on U.K. wordings but the holding of arbitrary retentions is peculiar to the Republic of Ireland only. It has been suggested that one particular Insurer, who are relatively new to the Irish market, are suggesting they won’t apply retentions as part of a marketing strategy. Perhaps to be commended, it is rather reflective of the “process driven“ approach by some Insurers which has undermined fundamental principles and the irony of an Insurer, using correct and proper procedures as a marketing tool should not be lost. If some Insurers choose to incorporate specific reference to arbitrary retentions in their Policy wording then I think it will highlight their competitive disadvantage as clearly those Insurers who do not incorporate such a wording will be obliged to follow the “traditional indemnity” approach. Again it must be emphasised that the current practice of imposing arbitrary retentions is not carried out by all Insurers.
In summary in the absence of a specific Policy condition referring unambiguously to the retention of a specific amount or in specific circumstances, Insurers should handle claims on well founded principles and legal precedent. The likelihood is that this practice will be exposed as a monumental abuse of the terms and conditions of the Policy and it is simply not good enough for those offending Insurers in this country to maintain a “take it or leave it” approach.
Alan FitzGerald, FCII., FCILA., FUEDI-ELAE., is a Chartered Loss Adjuster and expert witness and operates his own practice dealing with both Insurer and Policyholder instructions.
References/Citations
Marine Insurance Act 1906
Henry Booth & Sons –v- Commercial Union Insurance Company Limited (1923)
Castellain –v- Preston (1883)
Lonsdale & Thompson Ltd. –v- Black Arrow Group Plc and another (1993)
Elcock and others –v- Thomson (1949)
Reynolds & Anderson –v- Phoenix Assurance Company Ltd. & Others (1978)
Pleasurama Ltd. –v- Sun Alliance (1979)
Leppard –v- Excess Insurance Company Ltd. (1979)
Keystone Properties Ltd. –v- Sun Alliance (1992)
St. Albans Investment Company –v- Sun Alliance in London (1983)
Manor Park Homebuilders Ltd. –v- AIG (2008)
AMP Financial Planning Ltd. –v- CGU (2005)
Dermot Lathan v Hibernian Ins Co. (1991)
Harbuts Plasticine Ltd. v Wayne Tank & Pump Co. (1970)
Dominion Mosaics Co. Ltd. Trafalgar Trucking (1990)
Bacon v Cooper (Metals) Ltd. (1982)
British Westinghouse v Underground Ry Co. (1912)
“The Principle of Indemnity and its application” (CILA) RM Walmsley (1995)
“Damages for Third Party Property Losses” A.R. FitzGerald (CII Journal 2003)
“Insurance Law in Ireland, Austin Buckley” (1997)
“Fire Insurance Law & Claims” (CILA) Peverett (1981)