When you have a homeowners' insurance policy in place, everything covered under that policy is assigned a value. Your home, and most of its contents and components, are likely to decline in value over time due to age or wear and tear. This loss in value is known as depreciation.
Insurance costs and depreciation
When most people file claims against their homeowners' insurance policies, they are reimbursed for the actual cash value (ACV) of their damaged property. ACV is a measure of the value of insured property, but it is not the same as replacement cost value. Replacement cost is the actual cost to replace an item at its pre-loss condition, whereas ACV is calculated by subtracting an item's depreciation from its replacement cost.
If your homeowners' insurance policy includes replacement cost coverage and you file a claim for property damage, then you may be eligible for reimbursement to cover the depreciation of the affected items in question. In such a situation, the depreciation on the affected items would be considered recoverable. Recoverable depreciation is calculated as the difference between an item's replacement cost and ACV.
Depreciation is calculated by evaluating an item's replacement cost value and useful life, or the amount of time it's expected to last. Let's say your home is damaged by a storm and your television is destroyed in the process. Now let's assume you purchased that television two years ago, it was in standard working condition up until your home sustained damage, and the same model would sell in stores for $2,000. Let's also assume that the model in question typically lasts five years, or loses 20% of its value every year. In this situation, the actual cash value of your television would be $1,200, calculated as follows:
$2,000 cost of new television-(20% depreciation per year x 2 years) = $2,000-$800 = $1,200
Meanwhile, your total recoverable depreciation would be $800.
Non-recoverable depreciation is the amount of depreciation that is deemed ineligible for reimbursement under your insurance policy. If you have a non-recoverable insurance policy, your insurance company will only pay the Actual Cash Value of the items for which you file claims.
Let's say your roof sustains storm damage and needs to be replaced at a cost of $10,000, which is what you originally paid for the roof. Now let's say your roof has a useful life of 20 years but was already 10 years old at the time the damage occurred. Based on the useful life of your roof, it depreciates by 5% per year starting on the date of purchase (100% divided by 20 years). Therefore the insurance company will depreciate your roof by 50% (5% per year times 10 years), and your roof's actual cash value will be just $5,000 (original price of $10,000 minus depreciation of $5,000).
With a non-recoverable policy, your insurance company won't reimburse that $5,000 in depreciation costs; it will only reimburse you the actual cash value of $5,000. The missing $5,000 would therefore be considered non-recoverable depreciation.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.