Insurance Law Client Alert: Ordinance or Law Exclusion Bars Coverage for Forced Demolition of Nonconforming Remodel

In Reichert v. State Farm General Insurance Company (No. G046582, filed 12/28/12, ord. pub. 1/24/13), a California Court of Appeal upheld summary judgment for a homeowners insurer based on its denial of coverage under an ordinance and law exclusion for demolition of a home ordered by local authorities after discovery that construction did not conform to municipal design and federal floodplain regulations.

The homeowners attempted a remodel of their newly purchased house. After several modifications to the building plans to conform with and avoid other expensive and burdensome ordinances, but before construction was finished, city building inspectors discovered the project did not conform with city ordinances and FEMA floodplain regulations and ordered the entire building demolished. The homeowners sued their architect and contractor and made claim to their homeowners insurer. The insurer denied the claim on the grounds that the demolition was not an accidental loss and was excluded by the ordinance or law exclusion to the policy.

In affirming summary judgment for the insurer, the appeals court first noted the possibility that the loss was not an “accidental direct physical loss” under the first party coverage at issue. But the court pointed out that a factual question existed whether the loss was “accidental” from the standpoint of the insured. (Citing MRI Healthcare Center v. State Farm (2010) 187 Cal.App.4th 766, 781.)

However, the appeals court agreed that application of the ordinance or law exclusion was “fairly obvious.” The court noted a split in authority as to whether, after a loss from a covered peril such as fire, a first-party property insurer is required to pay for code upgrades needed to effectively replace the lost or damaged property, even if the required code upgrades mean the insureds effectively receive something better than they originally had. That is, whether a party whose house was non-compliant before the loss deserves a code-compliant house after the loss.

The Reichert court cited Bischel v. Fire Ins. Exchange (1991) 1 Cal.App.4th 1168, which held a property insurer was not obligated to repair a dock destroyed by careless and unauthorized mooring during a storm (a covered peril) to the extent of bringing the dock up to the condition local code required. Instead, the insurer was only obligated to pay to bring the dock back to its pre-loss condition. The Bischel court said that “the purpose of insurance is not to put the insured in a better position than he or she was before the loss but rather to compensate for the actual loss sustained.”

By contrast, the Reichert court stated that Fire Ins. Exchange v. Superior Court (Altman) (2004) 116 Cal.App.4th 446, severely criticized such a result for cases where the policy provides replacement cost coverage. The Altman court concluded that where an insured has replacement cost coverage, then it is “inherent” in the idea of usable replacement that, if required by code compliance, insureds will receive something better than they had before the loss if the policy contemplated replacement of the property.

The Reichert court concluded that the split in authority did not affect the immediate case, because the split involves situations where the loss is caused by a covered peril. However, the Reichert court said that Altman (and consistent out-of-state authorities) cases are instructive for noting that the clear intent of the ordinance or law exclusion is to exclude loss when it is the law or ordinance itself – as distinct from a covered peril, such as fire – that is the cause of the loss. The court said that there is a small but consistent body of cases that have routinely applied the law or ordinance exclusion (or its predecessor, the civil authority exclusion) to losses caused by enforcement of a building ordinance or law.

The Reichert court also dismissed the argument that the policy’s optional Building Ordinance or Law coverage affects the result. The optional coverage provided an additional 25% above the policy’s dwelling coverage limit for required code upgrades in certain situations. However, the court said that the option did not restore coverage which the ordinance or law exclusion otherwise removed, but merely provided additional coverage when there is a “loss insured” in the first instance. That is, there must still be a loss caused by a covered peril, and the law or ordinance exclusion means there is no coverage when enforcement of a law or ordinance is the peril.

Finally, the Reichert court rejected an argument that the efficient proximate cause of the loss was the third-party negligence of the architect and that the loss was covered despite the ordinance or law exclusion. The court said that insurers had responded to the third-party negligence argument by adding broad policy language to exclude losses caused by third-party negligence. The Reichert court thus refused to agree that the architect’s decision to deviate from plans was the efficient proximate cause of the loss sufficient to circumvent operation of the ordinance or law exclusion.

While the Reichert decision bolsters the enforceability of an insurer’s ordinance or law exclusion where the cause of the loss itself is the enforcement of an ordinance or law, it appears that resolution of the split in authority in California for increased building costs imposed by ordinance or law as the result of a covered cause of loss under replacement cost coverage will have to wait for another day.

This document is intended to provide you with general information about insurance law developments. The contents of this document are not intended to provide specific legal advice. This communication may be considered advertising in some jurisdictions.

January 25, 2013