The purpose of many insurance policies is to provide a replacement for lost, damaged or destroyed goods. Coverage may also include compensation for being unable to use the item or for other damages caused by the item’s loss.
However, how do we calculate the value of an asset (the property) under a policy and what should the policyholder expect to receive when they make a claim.
Replacement Cost Value
Some policies offer a “replacement cost” as a form of compensation for an asset. The replacement cost is relatively easy to calculate – it’s simply the cost to replace an asset with something of the same or equal value.
Replacement costs aren’t fixed. For example, if you have building’s insurance – the property market can go up and down and so can the value of a building. Similarly, if you were to insure a commodity item (like say, 10 tons of coffee) the value of that commodity can rise and fall on the market and so can the replacement cost.
In most instances assets, when they are covered by a replacement cost value, must be replaced before the policy will pay out – this prevents the policyholder from over-insuring the value of an asset (either by accident or for fraudulent purposes).
Actual Cash Value
Actual cash value is slightly different. When an asset is insured based on actual cash value it takes into account the depreciation of the asset when determining how much the policyholder will be paid. This isn’t the same as “book value” (which is an accounting determination as to how much the asset will be valued on the company’s books).
For actual cash value: Deprecation is, normally, calculated by the insurer allocating a “useful life” to an item (say a period of 10 years) and then the remaining useful determines the level of depreciation.
Depreciation = Remaining Life of Asset/Useful Life of Asset
So let’s say we insure a video camera that we’d purchased for £2,000. The insurer decides that the useful life for the camera is 5 years.
After 2 years of holding a policy – the camera is destroyed.
The Actual Cash Value is calculated as follows:
Actual Cash Value = Original Value x Depreciation
The useful life of the asset was 5 years, we had the camera for 2 years, so there were 3 years of remaining life on the asset.
Depreciation = 3/5 = 60%
Actual cash value = 2000 x 60% = £1,200
So our policy only pays out £1,200.
Fixed Value Replacement Cost
This is a slightly different method again. In this instance, the insurer allocates at the beginning of the policy a replacement value to the item. No matter how the item rises (or falls) in value in the interim – it is the fixed value replacement cost which is paid to the insured party in the event of a claim.