In property insurance, is the payout made at the new price or is wear and tear deducted?
A five-year-old printing machine burned down. Will the insurer pay the price of a new machine or deduct wear and tear? The two bases, how they differ, and not confusing them with carrying amount in the accounts.
When property is completely destroyed, the payout can be calculated on two different bases. Which one applies is written in the policy, and the difference often turns out to be very large.
Key points
- On an actual value basis: the property's wear and tear is subtracted from today's new price. For old property, the price of old property is paid.
- On a replacement value basis: the price of buying similar new property today is paid, and wear and tear is not subtracted.
- Which basis applies is agreed in the contract. Read the "loss assessment" or "amount of indemnity" clause of the policy before signing.
- Replacement value protection is broader, so with this condition the premium is usually higher.
- Wear and tear in insurance is not depreciation in the accounts. Carrying amount results from the method in the accounting policy. The insurer, by contrast, assesses the actual condition of the property.
- The payout does not exceed the sum insured. If the contract has a deductible, it is taken into account too.
- Set the sum insured at today's price, not the old purchase price. Otherwise even a replacement value condition will not work in full.
Example: the "Saodat Print" printing house
The printing machine was bought 5 years ago for 120 mln soum. Today an identical new machine costs 150 mln soum. The machine was completely destroyed in a fire. The sum insured is 150 mln soum, the unconditional deductible is 2 mln soum. The insurer assessed wear and tear at 40%. Amounts are hypothetical.
| Indicator | Actual value basis | Replacement value basis |
|---|---|---|
| Loss base | 150 − 40% = 90 mln | 150 mln |
| Deductible | −2 mln | −2 mln |
| Payout | 88 mln | 148 mln |
In the accounts, depreciation of 12 mln soum a year was charged on the machine: carrying amount 120 − 5 × 12 = 60 mln soum. This figure does not enter the payout calculation. Under an actual value condition, the printing house has to find 150 − 88 = 62 mln soum from its own funds for a new machine.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
A car was partly damaged in an accident: spare parts 8 000 000 soum, repair work 2 000 000 soum. The comprehensive (casco) insurance contract has a "new for old" condition: a 25% wear deduction applies to the cost of spare parts, with no deduction on labour (hypothetical terms). What is the insurance payment?
The insurance contract sets a coverage limit of 30 mln soum per event and an unconditional deductible of 2 mln soum (the deductible is subtracted from the loss, then the limit is applied; hypothetical terms). The loss from the event was 45 mln soum. How much does the insurer pay?
An insurer has concluded a quota share treaty with a reinsurer: 40% of the liability under each contract is ceded to reinsurance, and losses are shared in the same proportion. A loss of 25 000 000 soum occurred at a cotton warehouse and is paid in full. How much falls to the reinsurer's share?
An advance was previously paid for insurance (4510). Now the insurance payment has been accrued, and in the final settlement the advance was offset against this liability. What is the journal entry for offsetting the advance?
A liability was accrued for an insurance payment related to a new warehouse under construction (capital investment). What journal entry is made under NAS No. 21?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- Insurance fundamentals (general concepts) · indemnity on a replacement value and an actual value basis; the specific terms are set in each contract
- Example and amounts · compiled by the author, hypothetical