My shore house was flooded a few inches by Sandy and we cut out 12 inches of drywall and insulation that was water damaged. Is it necessary to replace the bottom 12 inches of insulation, or can I just replace the drywall. I've already begun the job without the insulation and am hoping its not necessary to rip out the work I've already done.

It would be the smart thing to replace it... Particularly in the climate in that area.

I would start replacing the insulation now and leave the previous uninsulated spaces alone. Is this a permanent or seasonal house?

For summer or winter you would be better off with insulation in walls. It will help with both A/C and heating.

If you installed S/R with screws and have not started taping, it is an easy remove.

Chuck