It's essential to protect the property where your business resides with insurance, but it's also important to know the difference between insuring your property for its actual cash value (ACV) and obtaining replacement cost coverage (RCV). Your company's specific needs will drive this business insurance choice, as will how much you want to spend on premiums.
Like a homeowners or personal auto policy, you can insure your business assets for their ACV or opt for RCV. Here's a look at both coverage types, how to determine which is right for your needs, how to calculate ACV and understanding depreciation.
What is actual cash value (ACV)?
Actual cash value is the current value of an item. If you insure for ACV on a business property item – such as inventory, equipment or furniture – and it's destroyed or damaged because of a covered event, an insurer will pay you its ACV after you file a claim.
ACV doesn't reflect what you paid for an item, but what it's worth in its current condition. The difference between what you paid and what it's now worth is the depreciation. We discuss how depreciation is calculated below.
What is replacement cost coverage (RCV)?
Replacement cost coverage represents a dollar amount you'd pay to replace your damaged or destroyed business property with something comparable. In policies, insurers often define comparable items using the term "of like and kind quality."
For example, if a computer were stolen from your company, the insurer would pay you the amount of money it would take to replace it – up to your policy limit. The reimbursement amount doesn't reflect any depreciation in value, unlike the ACV calculation.
RCV often comes with a higher premium because the insurer reimburses you for the actual current cost of the item. But there are important considerations when it comes to an RCV policy. If you've insured your property with RCV but set your limits too low, you won't have enough to replace your property adequately.
When should you insure your business with ACV?
There are several considerations when choosing your type of business insurance. You should opt for ACV if you want to reduce your insurance premiums and you can financially withstand a reimbursement based on a lower, depreciated value to replace your damaged item.
Here are some additional reasons to choose ACV:
- You're not fussy about the replacement item. Choose an ACV plan if you are comfortable using claim money from a loss to buy a similar – but depreciated – replacement item. For example, you'd use your money to buy an older, used model of your damaged business vehicle or equipment. You'd be OK with the older replacement serving the same purpose in your business.
- You have financial flexibility. Choose ACV if you have room in your company's budget to make up the difference between the claims payment and the cost for newer replacement items in the event of a loss or damage to property.
- You have newer equipment. Another reason to opt for ACV is if your business equipment is new, since the subtracted depreciation amount won't be as large as in older property claims. Consequently, the ACV claims payment will be closer to the replacement value in newer property than in older property.
How do you calculate ACV?
ACV is the cost of replacing or restoring your damaged item minus depreciation. Here is the calculation most policies use:
Replacement cost - Depreciation = ACV
Insurers typically use a straight-line depreciation schedule to determine the ACV of the asset.
Is the deductible included?
There is often a deductible associated with the ACV claims payment, so this may be the formula for calculating your actual claims payment:
ACV - Deductible = Actual claims payment
Refer to your insurance policy, which will list how the ACV is calculated in the event of a loss.
Is book value used?
Book value calculations are used for corporate accounting and tax purposes, and are different from ACV calculations. They base initial calculations on the cost of the item minus accumulated depreciation, rather than the cost to repair or replace the item minus depreciation.
Cost of the asset when purchased - Accumulated depreciation = Net book value
In generally accepted accounting principles, when an asset is purchased, an asset's book value equals the asset's initial cost. The book value declines over the years because of accumulated depreciation.
For example, when an asset is purchased – year 0 – its ACV, book value and replacement cost calculations can equal the same amount. For subsequent years, net book value often won't equal the calculation most insurers use in determining ACV.
How to calculate depreciation
Depreciation is the life expectancy of the item. To calculate straight-line depreciation, you take the actual cost of the asset and subtract its salvage value, then divide by the estimated useful life of the item in years. Salvage value is the estimated value of the asset at the end of its usefulness.
(Actual cost of the asset - Salvage value) ÷ Estimated useful life of the item (in years) = Annual depreciation
There are several different types of depreciation calculations, such as double-declining-balance depreciation. Contact your insurance agent for details on your insurer's calculations contained in the policy.
Other common ACV calculation variations
Depending on the circumstances, some insurers calculate ACV by the fair market value or broad evidence rule.
- Fair market value: This means the insurer calculates ACV based on what's equal to the fair market value of the damaged property.
- Broad evidence rule: The broad evidence rule encompasses additional factors in calculating ACV – including the property's assessed value, any purchase offers, and the condition and location of the property.
Your specific policy will detail how your insurer calculates ACV.
Your physical business assets
Before choosing ACV or RCV, determine the value of all physical business assets, including any property, plant and equipment (PP&E or fixed assets) listed on your company's balance sheet. You need to know the value of these items in your organization:
- Equipment
- Supplies
- Inventory
- Furniture
- Fixtures
- Vehicles
- Land and any structures
According to Scott Harris of The Hartford, you should retain all of the original purchase receipts for your business property. "For higher-value items, it is always a good idea to maintain records, such as photos and maintenance records. This information can help to mitigate the amount of depreciation applied when there is an ACV loss."
Keep these key considerations in mind when determining your company's assets:
- ACV and RCV: Some policies allow you to combine ACV for specific items under your policy and replacement costs for others. Because ACV includes depreciation, consider calculating your business's land valuation separate from the physical equipment you use to operate your business. Then, determine whether you'd like to insure your equipment for replacement cost.
- Fixed assets: If you don't rent a retail space and you own land and other significant fixed assets, consult with your accountant and insurance agent to determine the best plan. Consider both ACV and replacement cost options that will best suit your company's bottom line.
- Busy seasons: If your business has seasonal income or inventory values that vary by season, consider a peak season endorsement to further protect your business.
What is a peak season endorsement?
When insuring property for ACV or replacement cost, consider adding a peak season endorsement – or rider – to your policy. This endorsement will cover a more accurate property value in the event of a loss.
This endorsement type often includes a schedule for peak seasons and a higher insurance limit during specified time periods. Average monthly property values are often used in coverage calculations, and the policy limit is often equal to or greater than 100% of this average amount.
What is a coinsurance penalty clause?
Coinsurance penalty clauses are created mainly to protect the insurer. These clauses, often found on the insurance policy's declaration page, require you to carry a specific amount of insurance on the property based on the value of the property being covered.
For example, an insurer could require the amount of insurance you purchased on the property to be 80% of the property's value to cover repair or replacement costs adequately. In this example, the insurance limit would be 80% of the value of the property.
If you fail to meet this required coverage amount and file a claim on damaged property that exceeds the coverage limit, you'll face a penalty to make up for the inadequate insurance. Check your policy for specific coinsurance percentage requirements associated with your property's value.