UPDATED: Mar 13, 2020
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In most cases when you take out an insurance policy that covers property in the United States, the insurance will not cover the purchase of a brand new item to replace a battered old one. It will instead award you a benefit equal to the replacement cost of the item.
The replacement cost is the actual cost of the item which then has a depreciation calculation applied to it.
So what is depreciation?
It’s a calculation used for both insurance companies and accounting firms that enable the companies to find the real (true) value of an asset. Because over a period of time most things will become less valuable for example with a car you’d find that weather damage, general wear and tear etc. will reduce the value, it’s necessary for the insurer to work out how much your property is worth at the time it is lost or broken beyond sensible repair.
So when an insurer works out how much money they will pay against a claim made against a policy they have to take depreciation into account.
Here’s an example:
You buy yourself a new car and when you purchase it, it costs $100,000 to buy. Your insurer decides that the model you bought has an effective life span of let’s say 10 years. This is the period over which your vehicle will depreciate.
So in 7 years’ time your car will have lost 7/10th of its value, and as 7/10th of $100,000 is $70,000 your car will have depreciated by $70,000.
This means that the replacement cost is the original cost minus the depreciation, in our example this would $100,000 – $70,000 which leaves $30,000.
Actually depreciation calculations are a little more complex than this, partly because for auto insurance most cars lose a dramatic amount of book value when they are driven off the forecourt when they’re first purchased, but hopefully you get the idea about how it works.
Why does replacement cost matter to me?
It matters because this is the most money your insurer will pay to replace your car in the event that it is written off. In some cases depreciation can actually be greater than the remaining balance on a hire-purchase agreement which might mean that unless you have gap insurance – you’ll have to keep on paying for a car that you can’t drive anymore.