Overhead & Profit: Three Trades and More

 By Diana Reitz

From the January 2007 issue of Claims Magazine

 Overhead and profit. Three words that have been at the heart of a slew of questions to the FC&S editors in recent months.

 Many of the questions deal with whether or not overhead and profit (O&P) should be paid on a loss when less than three trades are involved. Others deal with whether O&P should be deleted in its entirety from an actual cash value settlement under a replacement cost policy.

Still others have different twists, but all of them focus on insurer guidelines for how O&P should be treated when adjusting claims.

For example, a Wisconsin subscriber phrases it this way:

 I have studied case law till I am blue. This is a question about the present view of the courts regarding overhead and profit due a general contractor. . .Is a true GC entitled to O&P if more than three trades are involved?

 I have a number of adjuster scopes that include it in the homeowner's scope of damages and I have many that do not include it, in the same situation, maybe homes on the same street.

 Another subscriber zeroed in on the question a bit differently:

 To get overhead and profit must the homeowner hire only a CGC and not a CC? If the homeowner hires a contractor that only has a county license is he entitled to overhead and profit?

 And yet a third, from an adjuster with an independent adjusting company, added another spin on the question of overhead and profit, this time asking whether a general contractor who also was the owner should receive overhead and profit payments under a builders risk policy:

 A fire loss occurred under a builder's risk policy. The insured constructed the dwelling as a general contractor, but he is also the owner. Is the insured entitled to overhead and profit if he reconstructs the dwelling post loss?

 Before discussing this issue let's take a moment to outline just what O&P entails. According to Peter M. Wells, president of MSB, writing in the glossary of the book Insuring to Value, 2nd Edition, there are two types of overhead: general overhead and job-related overhead.

 General overhead relates to a broad variety of costs typically involved in doing business: office staff; office rent; office supplies; office equipment; sales, marketing and advertising costs; finance charges, etc. Job-related overhead refers to costs other than labor and material costs that are directly related to a specific project: building permits, fees and inspections, utility hook-up charges, construction drawings (blueprints), surveys, erosion control (silt fences, etc.), construction driveway, culvert or curb cut, interior cleaning of the building prior to occupancy, and site security.

 Profit is defined by Mr. Wells as a positive return on investment. In building construction, remodeling, or reconstruction, it is the fee charged by a general contractor for construction services provided.

 The FC&S editors generally have taken the stance that O&P is a part of replacement cost and, thus, would be included in the replacement cost calculation, which then is depreciated to an actual cash value amount.

 Particularly in cases in which the insured owner is a contractor, we don't believe it should be automatically subtracted in a settlement. In responding to the inquiry from the independent adjuster about a contractor who rebuilt his own building, we said:

 It is our opinion that overhead and profit should be included in the replacement cost payment to a general contractor who rebuilds a structure he owns after it is destroyed by a covered cause of loss. After all, the contractor in such a situation loses the opportunity to earn overhead and profit on another job, which must be foregone in order to rebuild this structure.

 A 2006 case from the Pennsylvania superior court, Mee v. Safeco Ins. Co. of America, analyzes a similar question of whether an insured was entitled O&P when the insured, himself, repaired the damage. In that case, the insured owner was not a contractor, but the court still felt he should be able to recover O&P.

 The court emphasized that the insured had paid a higher premium for replacement cost coverage, which entitled him to O&P when use of a general contractor would be reasonably likely, even if no contractor was used or no repairs made.

 This class action suit for breach of contract and bad faith involved a replacement cost policy covering the dwelling of James Mee. The policy defined actual cash value as the "cost of repairing the damage, less reasonable deduction for wear and tear, deterioration and obsolescence."

 The insurer deducted 20% for O&P from its initial payment, and Mee subsequently presented a claim for this 20%. Requesting the name of the general contractor who would be doing the repairs, the insurer indicated that was needed as a basis for the payment. Mee sued, and the trial court granted summary judgment in favor of the insurer. Mee then appealed, arguing that general contractor O&P should be paid "automatically and unconditionally" whenever more than one construction trade would reasonably be required.

 The Mee court referenced another case from the Pennsylvania superior court, Gilderman v. State Farm Insurance Co. As referenced in the Mee case, the court explained that the issue in Gilderman was "whether an insurer, which has agreed to pay repair or replacement costs less depreciation in advance of actual repair or replacement of a covered loss, may automatically withhold both depreciation and a flat twenty percent" for contract O&P in its advance payment.

 The court said the answer to this question rested on whether use of a general contractor was "reasonably likely," which was a question of fact for a jury to decide. The Gilderman court established an objective standard by which an insurer could determine "on a case by case basis" whether to pay O&P.

 Using this logic, the Mee court said the operative issue was the reasonable likelihood of a general contract being used, not whether the homeowner did the work himself or not.

 As a practical matter, adjusters tell us that several software programs use the construction standard of three trades as a rule of thumb on the payment of O&P. But nowhere in any insurance policy have we ever seen the words "three trades required."

 The three trades threshold probably is a reasonable construction standard, but we don't think it can be used exclusively to decide whether O&P should be paid. The individual facts of a case may dictate otherwise, especially when an insured has paid additional premium for a replacement cost policy.