Depreciation

Reviewed by Stefan Tirschler

Noun

de·pre·ci·a·tion | dɪˌpriːʃiːˈeɪʃən

Definition: An accounting method that distributes the cost of an asset over its useful life.

Large corporations routinely apply depreciation to their assets for both tax and accounting purposes.

What is depreciation?

Depreciation, in simple words, is spreading the cost of an item across the years that the item is in use.

Every year that the item is in use, its value depreciates by one year until it reaches the end of its useful life. Useful life is an important part of depreciation; we’ll come back to it in a moment.

Depreciation is an accounting method. Businesses use it to spread out the cost of expensive purchases over several years.

There are several reasons accountants use depreciation. We won’t get too into the weeds of accounting methodology, but here’s the short version:

  • Matching expenses to the revenue that they create is an important principle of accounting. When a company buys a $100,000 machine that they expect will earn them money for 10 years, they spread that $100,000 expense over the 10 years.

  • Companies use depreciation on large expenses for tax purposes. It helps reduce their taxable income over the period of depreciation, rather than just the year they made the large expense.

Of course, we’re not here to learn how to be accountants; we’re here to learn about insurance terms.

What does depreciation mean in insurance?

Insurance companies use depreciation as part of the claim settlement process.

There are two main methods insurers use to decide how much money to pay an insured for a claim:

Replacement cost and actual cash value. Click either link for our full explanation of each term or keep reading for the abridged version.

Replacement cost is what it would cost to replace an item with a brand-new, similar item.

Actual cash value is replacement cost, minus depreciation.

Let’s start with an example:

Example

Martina has a tenant insurance policy to cover her personal property (among other things). A burst pipe in her basement suite ruins her expensive sectional sofa. She decides that she doesn’t want to replace it, so she asks her claims adjuster for a cash settlement.

Her adjuster determines that it would cost $6000 to replace with a similar, new sofa.

In our example, the $6000 is the replacement cost for the sofa. It’s the amount her insurer would pay to replace the sofa with a new one.

However, Martina chose to receive cash rather than a new sofa. Before paying her, the insurance company will apply depreciation to the replacement cost.

The depreciated replacement cost (a.k.a. actual cash value) is the amount Martina’s insurer will pay her for the claim.

That’s how insurers most commonly use depreciation. Most home insurance policies will repair or replace damaged property at replacement cost, but if the insured chooses cash instead, they will receive actual cash value.

Most policies have at least a few instances where payment will be on an actual cash value basis. Make sure to review your own policy or talk to your insurer to be sure how your own policy works.

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How is depreciation calculated?

There are many methods that accountants use to calculate depreciation, but we’re going to stick to the most common, simplest method: straight-line depreciation.

Calculating depreciation on an item for an insurance claim isn’t complicated.

Step #1

The first step is to set the item’s useful life.

Useful life is an estimation of how long we expect the item to be in use. Insurance adjusters consult various guides and regulations to find the useful life of items, rather than deciding on a case-by-case basis.

Let’s go back to our earlier example of Martina and her sofa, and say the sofa has a useful life of 10 years.

Step #2

The second step is to set the item’s replacement cost, which we already know is the cost of replacing the item with a new version of similar kind and quality. The replacement cost of Martina’s sectional sofa is $6000.

Step #3

The third step involves a little math.

We know the sofa’s useful life is 10 years, and its replacement cost is $6000. Now we can calculate depreciation.

We will spread the $6000 replacement cost over the 10-year useful life. That gives us $600 per year. The sofa’s value, therefore, depreciates by $600 every year.

$6000 / 10 = $600

(replacement cost) / (useful life) = (annual depreciation)

Step #4

The last step is to figure out the actual cash value. That means applying the annual depreciation for each year the sofa’s been in use and subtracting that value from the replacement cost.

Martina had owned her sofa for 6 years before the flood destroyed it.

$600 x 6 = $3600

(annual depreciation) / (number of years in use) = (total depreciation)

Since she bought it, Martina’s sofa has lost $3600 in value to depreciation. So, we subtract 3600 from the replacement cost…

$6000 – $3600 = $2400

(replacement cost) – (total depreciation) = (actual cash value)

…which gives us $2400. $2400 is the sofa’s actual cash value, the amount her insurer will pay her in cash to settle the claim (minus her deductible).

At Square One, we also use what’s called limited depreciation. When limited depreciation applies, we won’t depreciate replacement value below 50%, no matter how much useful life remains.

The important points

  • Depreciation means spreading the value of an item over its useful life.
  • Insurers normally pay claim settlements on either a replacement cost or an actual cash value basis.
  • Insurance companies use depreciation to calculate actual cash value.
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