Recoverable depreciation is an important concept in the insurance industry. If you’re in the process of making an insurance claim, then it’s important you understand how recoverable depreciation works.
You may already know about depreciation. Depreciation is the method of allocating the cost of an asset over the course of its useful lifetime. When you sign an insurance policy, your insurance company is likely agreeing to cover the replacement cost of the covered item – like your house.
When your insurance policy covers replacement costs, it means that some or all of your depreciation can be claimed. This is known as recoverable depreciation.
How Does Depreciation Work?
A homeowners insurance policy is a contract that agrees to provide coverage for your house and the contents of your house. That insurance policy coverage will need to assign a value to everything covered under the policy in the event of a claim.
The value of your home and the contents within your home decline over time. Some items – like your home – decline in value due to normal wear and tear. A 5-year old home with brand new everything is generally worth more than a 25-year old home that needs a new roof. This is the same with your personal property contents within your home.
The amount that is lost each year in value from your home and the items inside is called depreciation. Depreciation might sound complicated, but it’s a surprisingly basic formula.
Let’s say you purchased a new oven for $2,000, and the expected lifespan of that oven is 10 years. The insurance company will establish that this oven has a useful life of 10 years. Based on this information, the annual depreciation allowed per year is the total cost divided by the total expected lifespan (useful life), which works out to:
$2,000 (the initial cost and value of the oven when brand new) divided by 10 years (the expected useful lifespan of the oven) = depreciation of $200 per year
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How Insurance Companies Calculate Actual Cash Value (ACV)
Depending on your policy, when filing an insurance claim your insurance company will often pay you the actual cash value (ACV) of the personal property that was damaged or destroyed. ACV is a measure of the cash value of the asset at the time it was damaged or destroyed.
To determine the ACV of an asset, the insurance company will calculate the replacement cost of the item (what it would cost to replace the item), then subtract the depreciation of that item from the replacement cost.
In the example above with the oven, here’s how the insurance company would calculate ACV if the oven was destroyed after 3 years:
Oven ACV = $2,000 – ($200 x 3) = $1400
In this case, your insurance company would reimburse you $1400. On an actual cash value basis you’re not going to receive the full replacement value of the oven or the price you paid at retail because the oven wasn’t worth that much at the time of its loss. The oven depreciated in value over the 3 years of usage, and your insurance company will reimburse you for the actual cash value – or ACV – of that asset.
Insurance Policies Can Have Recoverable Depreciation Clauses
Now that you know how depreciation works, it’s time to talk about recoverable depreciation.
You can have a recoverable depreciation clause in your insurance policy. A recoverable depreciation clause allows the homeowners to claim the depreciation of certain assets along with their actual cash value.
In the example above, then you may be able to claim the depreciation of the oven – or $600. This is the amount of value depreciated from the oven over a 3 year period.
Rules and Restrictions of a Recoverable Depreciation Clause
A recoverable depreciation clause might seem like a good idea – after all, it’s more money in your pocket in the event of a loss. However, most recoverable depreciation clauses come with rules and restrictions.
First, many recoverable depreciation clauses come with rules requiring certain repairs or replacements to be completed within a certain deadline. If you failed to make these repairs or replacements prior to the loss of that item, then your recoverable depreciation clause may be void.
It’s also important to note that home insurance plans have a deductible. Recoverable depreciation can make a significant impact when it comes to calculating whether or not it’s worth it to file a claim.
As a simplified example, let’s say you have a $1,500 deductible, and your insurance company is offering you $1400 for your 3 year old oven (actual cash value). At this point, it’s not worth it to file an insurance claim because your deductible is more than the amount of compensation you’d receive. However, if you had a recoverable depreciation clause in your insurance policy, then your insurance company would reimburse you $2,000 total ($1400 ACV plus the $600 in depreciated value over 3 years). This means you’re at a net positive of $500 for your insurance claim.
Recoverable depreciation can add a significant amount of value to your compensation. In many cases, your covered asset has depreciated by 50% or more in value since you purchased it. That means your insurance company might offer a settlement that’s twice as much as what you would receive without recoverable depreciation.
Sometimes, there are rules and restrictions that make it hard to claim recoverable depreciation. In other cases, it’s extra money you should be aware of that may be available on top of your existing insurance claim.
Ultimately, talk to your insurance company or check your insurance policy to determine if you have a recoverable depreciation clause.