Insurance Breakage—Why Do Insurance Regulators Approve Arbitrary Time Limits for Replacement?

Have you ever received gift cards only to forget about them or not use them for years? Consider the fairness of this scenario: companies sell gift cards and then retain all the revenue when these cards go unused within a specified period. This practice raises questions about consumer rights and corporate responsibilities.

A parallel situation is unfolding in the insurance industry. Take, for instance, a recent case in Virginia involving State Farm.1 The company is insisting that its customer must “complete” repairs on a fire-damaged building within a two-year timeframe. This demand brings to light a critical issue: why do insurance regulators sanction clauses that impose such arbitrary time limits? These clauses effectively promote a concept akin to ‘insurance breakage,’ allowing insurance companies to potentially reap financial benefits from unreasonably stringent deadlines.

The core issue here is the potential for insurance companies to gain unfairly from these arbitrary time constraints. When policyholders are unable to meet these deadlines due to various reasons, they might find themselves inadequately compensated, or worse, they’re denied because of nothing other than a deadline that has no apparent basis other than to create a windfall for the insurance company. This situation is particularly concerning given the nature of insurance as a safety net for policyholders in times of distress.

The recent Virginia case that drew my attention to this national issue has these facts:

Bowman’s house was severely damaged by fire on March 24, 2020, and he made a timely claim to State Farm under his policy. State Farm began to investigate, and in October 2020, provided Bowman a first estimate of the cost to repair his house, as well as an initial actual cash value payment. In addition to enclosing a 60-page breakdown of estimated repair costs by room and item, the letter attached an ‘Explanation of Building Replacement Cost Benefits’ form, which stated that ‘[t]o receive replacement cost benefits you must … [c]omplete the actual repair or replacement of the damaged part of the property within two years of the date of loss.’

It took State Farm six months after the fire to provide its policyholder an estimate of the fire loss. As the two-year time limitation to file suit approached, the policyholder filed suit:

State Farm paid Bowman the actual cash value of the damage to his home and then told Bowman that he had to complete any repair or replacement within two years of the date of the loss. Just before the two-year mark, Bowman filed an action for declaratory relief, asking the circuit court to interpret the insurance policy and hold that State Farm could not refuse to make payments for repair or replacement costs incurred after two years from the date of loss. State Farm demurred, arguing that Bowman could not bring a suit unless he had complied with the policy, which required him to complete repairs or replacement within two years.

The Virginia trial court agreed with State Farm. The appellate court reversed, finding that any two-year time frame was ambiguous:

State Farm has argued that the policy does not require it to reimburse Bowman for costs incurred after two years from the date of loss. As discussed above, the policy is ambiguous on this point. Should the factfinder conclude that the policy does not require Bowman to complete repairs within two years, and State Farm relies on the ‘Suit Against Us’ provision and refuses to reimburse him, there is at least some possibility that Bowman might be entitled to relief. Therefore, the circuit court was wrong to conclude that there was no justiciable controversy presented here.

My research has found no explanation for why many insurance companies place a time limit requirement in replacement cost policies. I have several practical guesses, including a major underwriting risk—insuring a risk that is in disrepair. However, I have found nothing in any research explaining a rationale for why some insurance companies placed this provision into the property insurance policy. If any reader has an actual source explaining the rationale for these arbitrary time frames, I would greatly appreciate you forwarding it to me.

In my view, the obligation of an insurance company to pay for replacement costs should hinge primarily on whether the company has suffered financial prejudice. The breach of a time frame for repairs or replacements should not be deemed material unless it demonstrably results in financial detriment to the insurer. Given that most courts are averse to the forfeiture of contracts, it stands to reason that an insurance company should only be able to withhold payment for delayed replacements to the extent that it can prove financial prejudice caused by the delay.

Absent such prejudice, it appears to me that the insurer is essentially profiting from holding onto ‘the float’ – the funds that are due to policyholders for repairs or replacements. This practice raises significant ethical questions. It suggests that the insurer benefits financially from the time value of money that rightfully belongs to the policyholder, especially when the delay in replacement does not materially affect the insurer’s financial position.

Therefore, the focus should be on the actual impact of the delay. If the delay does not financially harm the insurer, withholding payment seems more like a strategic financial gain than a response to a legitimate contractual or financial issue. This perspective aligns with the principle that insurance should serve the interests of policyholders, providing them with the security and financial support they are entitled to under their policies.

Arbitrary time deadlines for replacement are just another form of the insurance breakage problem I noted in Insurance Breakage—Insurance Companies Profit When Policyholders Give Up. As we delve into this issue, it’s crucial to examine the role of insurance regulators and the need for policies that prioritize the interests of policyholders. The concept of ‘insurance breakage,’ much like the unused gift cards scenario, highlights a significant gap in consumer protection that needs addressing. It’s time to reevaluate these practices and ensure the insurance industry remains true to its core promise of safeguarding policyholder interests.

Thought For The Day

I love deadlines. I like the whooshing sound they make as they fly by.

—Douglas Adams

_______________________________________

1 Bowman v. State Farm Fire & Cas. Co., No. 1256-22-3, 2023 WL 8040862 (Vir. App. Nov. 21, 2023).