When a property loss occurs, how the insurance carrier determines the amount of indemnification is an important concern. In general, the insured will be paid the lessor of:
•Actual Cash Value
•Cost to Repair
Actual Cash Value
Actual cash value, or ACV, is usually calculated by determining the item’s replacement cost (i.e., what it would cost to buy a replacement) and subtracting an amount for depreciation.
Replacement Cost – Depreciation = Actual Cash Value
Depreciation is subtracted because the insured has already had the use of the property. If the full amount were reimbursed so the insured could replace it with a new item, the insured would be better off after the loss than before. This violates the principal of indemnity in which the insured should not profit from a loss but should be returned (as near as possible) to the same financial position that existed before the loss occurred.
Although actual cash value is a common method of reimbursing a loss, the insured may be reimbursed on the basis of the item’s repair cost when the amount is less than the actual cash value.
Replacement Cost and Functional Replacement Cost
In some policies, the insurance company agrees to automatically pay replacement cost for covered losses, with no allowance for depreciation. This is known as replacement cost. The property will be replaced with materials of “like kind and quality” used in the original property.
Some policies pay losses on a functional replacement cost basis, where damaged property is repaired with less expensive, but functionally equivalent, materials. This method is used most frequently for losses to antique, ornate or custom construction.
While replacement cost is usually the preferred method of loss payment, ACV may be the only method offered by the carrier due to the age, condition and lack of upgrades of the property to be insured.
Reference: BISYS – Property‐Casualty Concepts, 10th Edition