Valuing War Damage for Financial Compensation

Valuing War Damage for Financial Compensation

Photo: ua.depositphotos.com / sarymsakov
18 April 2023
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One of the most pressing issues for after-war reconstruction is the compensation to people and businesses for lost assets. How to define the monetary value of the compensation? In this article we answer this question with respect to several types of assets. 

On 14 November 2022, the United Nations General Assembly passed a resolution (document A/ES-11/L.6) on “Furtherance of remedy and reparation for aggression against Ukraine”. This resolution specifically recognized the need to establish “an international mechanism for reparation for damage, loss or injury arising from the Russian Federation’s internationally wrongful acts”.

On 17 February 2023, the Dutch government agreed to establish an international organization in the Hague called the Register of Damage Caused to Ukraine by Russian Aggression. The register is intended to become the first component of a comprehensive reparations mechanism to ensure that the Russian Federation pays full financial reparations for war damage.

In this article, we focus on how best to determine financial compensation for various types of claimants whose assets and companies have suffered damage, destruction, or expropriation (which was very common in the occupied territories) due to the war, that is transparent, consistent, and fair.  Although we discuss valuation issues in some detail, the article is also intended for professionals in various disciplines that are engaged in or interested in the process of determining financial reparations. We focus on the current Russian invasion of Ukraine, however, much of what we discuss concerning valuation for compensation is generally applicable to other conflicts as well. 

In the following article sections we discuss: 

  1. Application of the Fundamental Principle of Financial Compensation as it pertains to asset and business valuation for financial compensation; 
  2. The use of International Valuation Standards (IVS) and methodologies to consistently determine the value of financial compensation for owners of assets and companies;

III. The requirements for evidentiary documentation of damage, destruction, or expropriation due to war;

  1. Expanding the scope of compensation to include valuation of all components of asset and company value that were negatively affected by the war, directly or indirectly; 
  2. Establishing consistent valuation dates and time frames applicable to the valuation process for all relevant components of asset and company value;
  3. Recommendations on how to move forward expeditiously with an expedited compensation process.
  4. The Fundamental Principle of Financial Compensation

The fundamental principle of financial compensation is that claimants are entitled to that sum of money which will put them in the same position as they would have been in if they had not sustained the wrong for which they are now receiving compensation or reparation. 

For any international compensation mechanism, such as that envisioned by the United Nations for Ukraine, to be seen as fair and justly enforceable, the financial valuations of assets and companies unpinning compensation claims must be seen as reasonable and defensible. 

Regardless of which legal mechanisms or avenues are followed to seek financial compensation, be it as envisioned by the United Nations, or be it through other established legal avenues, financial valuations of assets and companies must be transparent, consistent, independent, and comply with internationally recognized valuation standards. Fair financial compensation must be based on similarly fair valuation that does not favor any party to a dispute. Financial valuations must be acceptable to international authorities and not just to the National authority where the assets and companies are located. 

International Valuation Standards

The International Valuation Standards (IVS 2022) promulgated by the International Valuation Standards Council (IVSC), have long been applied globally to determine asset and company value within myriad compensation adjudications. Following the appraisal Standards as set out in IVS 2022, will ensure that the financial values supporting compensation claims are reasonable and defensible, as well as consistent and transparent across sovereign jurisdictions.

Although IVS does not explicitly address the topic of valuation of war damage for the purpose of financial compensation, current methodologies for determining value are directly applicable and readily applied. The circumstances of each compensation case will determine which IVS ‘basis of value’ is most applicable, as discussed below.

Basis of Value for Compensation

There are three general categories to consider:

  • Damage and destruction of assets and companies
  • Expropriation of assets and companies
  • Economic damage to assets and companies

The appropriate basis of value to apply in determining financial compensation is case specific. For example, if income generating assets or an entire company are expropriated, Market Value may be the most appropriate basis of value to determine compensation. For damaged or destroyed assets such as buildings, infrastructure, machinery, or equipment, Reinstatement Cost may be the most appropriate basis of value for determining compensation. We discuss both bases of value below.

Market Value

Market value as defined in IVS 2022 incorporates the effects of prevailing economic circumstances on asset and business value. These include such war-driven effects as inflation; recession; heightened risk and higher interest rates; damaged and destroyed general public infrastructure, the negative effects on supply chains and value chains, and so on.

Market Value is often the most appropriate basis of value for determining asset or company value prior to the start of the war. Determining Market Value prior to the start of the war establishes a benchmark or baseline value of the affected assets or companies before the occurrence of damage, destruction, or expropriation.

Reinstatement Cost  

Reinstatement Cost is a particularly useful basis of compensation for damage and destruction of assets as it includes all costs that must be incurred to replace the lost utility of an asset with a current replacement asset of similar utility. This would not include any consideration of the physical or other forms of depreciation present in the asset as of the date of damage or destruction because assets cannot be rebuilt with depreciation. 

For example, in the case of a destroyed ‘mid-market’ nine-floor residential apartment building, the total replacement cost would include all costs required to reconstruct that building to the same size, configuration, functionality and asset class as of the date of reconstruction. This may include preparation costs (Including, for example, design and permitting costs), demolition, debris removal, demining, temporary protection costs, removal of hazardous or contamination material, environmental remediation, costs for interim leasing, and the effects of exchange rate fluctuations and inflation during the demolition/planning/reconstruction period, and all required taxation.

In some cases, rebuilding may be impossible or infeasible because an entire city or village has been destroyed. In such cases the amount of compensation must be sufficient to purchase property with the same utility but at another location. Full compensation would include the pre-war Market Value of property that was destroyed as well as reinstatement costs incurred for moving and interim living expenses between the date of destruction and the date at which compensation is received.  

For machinery and equipment full replacement cost would include such additional costs as transportation, insurance, and installation. For land, full compensation would include demining, environmental remediation to remove hazardous items or mitigate various types of contamination, as well as the loss of fertility in the case of agricultural land. 

In the case of public infrastructure assets, such as those providing energy, water, heat, and transportation services, as well as social-sector assets such as schools and hospitals, compensation would need to be based on Reinstatement Value to provide the same utility as of the date of reconstruction.  

In the case of a business or an income generating asset, financial compensation must include both the lost value of the asset as well as the revenue or profit, as defined, lost by the business or asset owners because of the damage, destruction, or expropriation. This principle is often referred to as the ‘but for’ assumption: the value or profit that would have accrued to the owner of the asset or business ‘but for’ the physical or economic damage, destruction, or expropriation of the asset or business.

Economic Damage

In some business cases, loss of revenue and profit may occur without company assets having been damaged, destroyed or expropriated. This situation may arise because of the effect on normal business operations from the war. For example, in Ukraine the war has blocked most maritime trade through the Black Sea and Azov Sea ports, resulting in trade being lost or partially diverted to land routes at significant additional expense and loss of revenue and profitability.  In this case economic damage is calculated as the difference between no-war conditions and those resulting from the war.

Other principles and procedures germane to valuation for the purpose of financial compensation, include the challenge of sourcing data, and compiling documentation sufficient to meet rigorous evidentiary standards.  

Documenting War Damage

Identifying and describing an asset or company sharpens the focus of valuation and helps to justify the valuation conclusion. Although it is challenging in a war zone to identify and document expropriated, damaged, or destroyed assets and companies, submission of a compensation claim requires documentary evidence of expropriation, or evidence quantifying the degree of damage or effective destruction of assets or companies, that forms the basis of a financial compensation claim. Damage or destruction must be demonstrated to be a direct result of the conflict and not simply asserted without sufficient substantiation.

Documenting war damage claims for compensation requires more than just photographs. An integrated, dynamically interactive National cadaster system, for real estate (land and improvements) is a valuable technical asset to support damage claims. This is particularly so when damage is widespread and diverse, and when the case requires a ‘before’ and ‘after’ valuation. Cadaster systems help to bring transparency to the process.  

Components of Compensation

Full compensation requires quantifying each financial component of loss. The cost to return a damaged or destroyed asset to its original (but-for) condition (renewal) is one part of total compensation. Compensation for lost income is an additional component. For example, a commercial rental property may suffer significant physical damage. The property will also most likely suffer a significant decline in business income from the property owing to the damage and the resultant loss in utility. The property owner may also incur significant cash costs to make necessary emergency repairs. Both the value of the building and the value of the business have been negatively affected. In this case, financial compensation may claim the full cost of physical asset renewal (the cost to return the asset to its but-for utility and value), plus the loss in business income, plus the cost of emergency repairs and other interim expenses incurred during the period from the date of the damage event to the date compensation is received. 

At some point, it is necessary to delineate the compensation ‘space’ for assessing financial redress. It is possible, for example, to estimate the economic damage to an entire industry within a nation, such as the hospitality industry, or the maritime trading industry, to quantify the losses in business profitability and business value, as well as tax revenue lost by the government. Whether to define the compensation space narrowly or broadly is a very important issue in determining full compensation responsibility. 

Valuing Non-Income Generating Assets

For damage to assets such as residential buildings, the valuer must determine if it is economically feasible to repair the damage, such that the building returns to its ‘but for’ or ‘renewed’ condition, or if the damaged asset must be entirely replaced. For example, a building may suffer damage to the roof, and although the owner may prefer to replace the entire roof, compensation may be limited to the cost of repairing the roof.

If a building can be renewed through repair, full compensation will include the costs of repair plus the costs incurred to maintain the building during the interim period from the date of damage to the date at which financial compensation is received. This latter component may be significant as the elapsed time between the date at which an asset was damaged to the date at which financial compensation is received may be quite long. 

In specific cases where a building cannot be justifiably repaired to achieve renewal of lost utility, determining financial compensation is more complicated. For example, if an apartment building is destroyed, can the owner or owners (a condominium) rebuild in the same location? It is not uncommon for entire neighborhoods or even entire cities to be destroyed in war and reconstruction of buildings and infrastructure can take many years. In this case, full compensation may need to be based on the Market Value of the lost property, as it was just before the start of the war, plus costs incurred by owners to live elsewhere in the interim between destruction and receipt of financial compensation.

The time required to repair or replace an apartment building for owner occupation also includes the time needed to repair or replace public infrastructure required to support building occupation. A building may be privately owned but infrastructure for utilities or transportation access are most often owned by government or utility companies. The time to renew infrastructure may extend beyond the time to renew the building. Any negative financial or economic effects of such a situation must also be included in full compensation.

Consideration should be given to creating compensation options whereby, for example, a private owner of a single apartment in a building destroyed during war may opt for compensation in the form of a lump sum payment based on full compensation for the cost to reproduce the Reinstatement Value of the destroyed property, as of the date when compensation is received, and possibly including interim expenses incurred by the property owner between the date of destruction and date of receiving the compensation award. 

Concerning other tangible assets such as automobiles or other forms of moveable property, compensation can be based on Reinstatement Value as of the date of reconstruction or replacement, or Market Value of the assets before the date of damage, destruction of expropriation, as a specific case requires, including interim expenses. 

Valuing Income-Generating Assets and Businesses

Determining a reliable and defensible market value of a business, or an income-generating asset (sometimes referred to as a Cash Generating Unit or CGU) such as a commercial office building, is readily achieved by following IVS 2022 standards and procedures. The valuer will apply either a business valuation approach or an asset valuation approach to determine market value. 

Financial valuation can be based on a partial or total loss of the income stream from the business or income-generating asset (or asset group) as a result of damage, destruction, or expropriation or a temporary loss of income. Assets or companies located on the annexed or occupied territory may be considered as effectively expropriated. 

Valuation of income generating assets and companies must include not only lost income but also the cost of asset renewal. The same considerations discussed above, concerning the cost and timing of asset renewal, or related infrastructure renewal, apply here as well.  

Valuation Dates

There are various valuation dates and specific events must be identified and agreed upon prior to the valuation process. These will vary among assets and companies on a case-by-case basis. These dates and events are set out below.

  1. The date at which damage, destruction, or expropriation occurred. This date is particularly relevant for compiling information in support of a war-related compensation claim.  
  2. The date at which a damage claim is submitted. This date may be significantly after the damage event. Depending on the length of time that has passed between the event and the claim, asset and business value may have changed significantly and other costs incurred in the interim may have occurred. 
  3. A complete compensation claim includes redress for the cost to renew the asset or business to the same value and utility as of the original date of valuation, plus any documented applicable cost incurred by the asset or business owner in the interval between the date of the event and the date compensation is received. This could, for example, include the cost of interim repairs made to an owner-occupied property, or the cost incurred from losing access to owner-occupied property. It is, however, often difficult for a valuer to determine these costs given difficulties with compiling sufficient documentary evidence of the cost or loss. Therefore, compensation and the valuation supporting it may likely include only the renewal value as described above. 
  4. The date at which financial compensation is received. There can be a significant length of time between the date a compensation award is made and the date at which compensation is received. The longer this period, the larger the cumulative loss in asset or business value and the more the financial award itself depreciates. It is therefore necessary to agree upon a formula for updating a compensation amount from the date compensation was awarded to the date compensation was received to account for inflation or currency fluctuation. 

Recommendations

Given the challenge and scale of the loss to property and income from the Russian invasion of Ukraine, there is a need to move urgently, in a coordinated, international effort to avoid having stakeholders potentially work at cross purposes, or simply waste time.

  1. To avoid the perception of ‘conflict of interest’, any compensation mechanism should ensure that the compilation and verification of supporting information, and the valuations to determine financial compensation, are made by, or verified by, independent experts who do not act in favor of any party. Although it is understandable that various ministries of a national government,  international institutions, private companies, and other stakeholders, will develop damage assessments and valuations, it is unlikely that disparate efforts will meet the standards of independence, consistency and professional rigor that are needed for financial compensation decisions to be seen as fair and justifiable. There is a need for coordination and consolidation of responsibility in any compensation commission.
  2. To ensure consistency of methodology and approach, the UN compensation commission and the valuers who will be working on behalf of this commission and of international courts should adopt IVS 2022 as the foundational standard and adhere to it. Modifications or departures may be needed on a case-by-case basis.
  3. The scope of potential compensation should be established ex ante to any valuation process. It is important to clearly delineate which direct or indirect effects negatively affecting value or income will be within the purview of the valuation process and the compensation authority.
  4. Artificial Intelligence (AI) solutions are required for the entire valuation and compensation process, from initial identification and documentation of claims to valuation and compensation. Technologies such as satellite imaging, cadaster systems, mass appraisal algorithms, and the digitization of claims, should be incorporated into the valuation and compensation processes to ensure consistency, reliability, and most importantly, timeliness of compensation. The scale and complexity of the challenge requires a central coordinating body with international standing. 

It will be challenging for individuals and companies in Ukraine, as well as the Ukrainian Government, to meet rigorous international evidentiary standards to document damage, destruction and expropriation of assets and companies. Ukraine lacks a National Cadaster (for real estate, not just land) designed to international standards. Although public and private information exists in various forms and locations, there is no current mechanism to consolidate such information across asset classes, cities, or regions. In general, existing information sources are often not consistent, complete, current, or verifiably accurate. It is highly recommended that the Ukrainian Government focus on this issue and begin to lead in the development of an internationally acceptable real estate Cadaster and information systems.  

The United Nations has clearly stated the need for those responsible for “internationally wrongful acts” to provide redress. It is now incumbent upon the international community to move with the urgency the situation demands. Time, if wasted, will only add to the losses and personal suffering of those victimized by the wrongful acts. We hope this article will contribute to this effort. 

Authors

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The authors do not work for, consult to, own shares in or receive funding from any company or organization that would benefit from this article, and have no relevant affiliations