Know Your Insurance Terms!
Replacement cost of any asset should not be confused with the market value of the asset. While the market value may vary according to inflation, replacement cost is the cost of a comparable asset of that damaged asset.
If you have an insurance policy for your property/asset, you may have come across the financial terms actual cash value and replacement cost. Mostly these terms are used in commercial insurance―insurance of property /fixed assets of any entity, and they are used for valuation purposes. However, if you aren't too familiar, let us explain.
Simply put, Actual Cash Value = Replacement Cost - Depreciation.
While this equation may have made understanding the terms a little easier, yet some explanation will be required. Let us highlight the difference between these financial terms, with an example to explain what is their impact on your indemnification.
|Actual Cash Value||Replacement Cost|
|◾ It is the value of a property which you will receive if you sell the property. In other words, it is the replacement cost, reduced by depreciation of that asset.||◾ It is the cost which is required to be paid, to replace the existing asset with another comparable asset of similar quality.|
|◾ In case of an insurance policy which pays you the actual cash value if your property gets damaged, they (insurer) will pay an amount equal to replacing your asset; however, after factoring in the age of your asset and reducing the value on a pre-determined pro-rata basis.||◾ If you opt for this insurance policy, at the time of damage or loss to the asset, the insurance company will pay you an amount required to replace the asset at the prevailing market conditions, regardless of the age of your asset.|
|◾ The insurance premium in this case is lower than a replacement cost insurance.||◾ The insurance premium, in this case, is definitely higher than the other one since depreciation is not taken into account.|
|Example for Comparison|
|Calculation of insurance amount payable by the insurance company in both scenarios:
|◾ You will receive an insurance amount of USD 2,000||◾ You will receive an insurance amount of USD 7,000|
Points to note:
- Depreciation is the reduction in the value of any asset due to wear and tear, efflux of time, etc. The method of calculating depreciation and the actual cash value of the asset might be different for every insurance company. Read the policy terms and discuss with the insurer before taking up any policy.
- For calculating 'replacement cost', the price of an asset which resembles the quality and standard of the original asset is considered.
- The reason for insurance is to indemnify the insured of his loss and not make any profit to him. Thus, though replacement cost is high, it is compensated by paying higher premium to the insurer.
Whether to opt for an insurance coverage that pays you the actual cash value or the replacement cost, will depend on a number of factors. Your needs must be considered before taking any decision―whether you can afford high premiums of replacement cost, nature of your asset, age of your asset, etc. Of course, seek professional help to do your calculations, as every insurance company has a different set of terms, conditions, and policies.