Habitational Insurance FAQs: What Is Depreciation?

Depreciation in insurance refers to the loss in value of an item over time. It can be due to wear and tear or obsolescence. When an insurer provides coverage for an item, they do so based on the item’s current value. If the item is damaged, the insurer will only pay out up to the item’s current value minus any applicable depreciation.

It can be challenging to wrap one’s head around, so let’s use an example. Let’s say you own a 10-year-old car that you insure for $10,000. If the car is totaled in an accident, your insurer will only pay out $5,000 since the car is only worth half of its original value after ten years.

What is the difference between actual cash value and replacement cost?

The two most common types of insurance coverage are actual cash value (ACV) and replacement cost (RC). ACV policies pay out the current market value of an item at the time of loss, while RC policies pay to replace the item with a new one of similar quality and condition.

Things to remember when choosing between ACV and RC coverage:

1. ACV policies are usually less expensive than RC policies. ACV policies only pay out the current market value of an item, while RC policies pay to replace the item, which is typically more expensive.
2. ACV policies may not cover the total cost of replacing an item. It is because the value of an object can depreciate over time. For example, a five-year-old car will be worth less than a new one. If you have an ACV policy and your vehicle is totaled in an accident, your insurance company may only pay out the car’s current market value. This could be less than what you owe.
3. In some cases, ACV policies can be challenging to obtain since most insurance companies today offer replacement cost coverage.
4. ACV policies can have low limits since they may not cover the total cost of replacing an item. For example, if you have a $20,000 limit on your ACV policy and your car is totaled in an accident, your insurance company will pay $20,000 toward replacing your car.
5. RC policies will typically only pay out based on ACV until the repairs are completed. Once the repairs are made, the additional funds (RC) will be paid out. 
6. ACV policies are generally less expensive and may be easier to obtain than RC policies. However, they may not cover the total cost of replacing an item and can have low limits. You should carefully consider whether ACV or RC coverage is suitable for you.

How is depreciation calculated?

Several methods help calculate depreciation, including:

1. Straight-line method: This approach takes the asset’s cost and divides it by the estimated years that the asset will be in use. For example, if a company buys a piece of machinery for $100,000 and expects it to have a useful life of 10 years, the straight-line depreciation expense would be $10,000 per year.
2. Declining balance method: This uses a fixed rate (usually double the straight-line rate) to calculate the depreciation expense in the early years when the asset is at its highest value. The depreciation expense then declines over time as the asset loses value.
3. Sum-of-the-years’-digits method: This method weights the depreciation expense higher in the early years and lower in later years. 
4. Units-of-production method: There are cases when the asset’s value is directly tied to its output. For example, this method would calculate the depreciation expense for a factory machine producing a certain number of products yearly.

If you have any questions about how depreciation works or how it may affect your insurance claim, be sure to speak with your insurer. They can give you specific information about your policy and coverage.