Actual Cash Value
the real market value for which an asset could be sold, which is equal to replacement cost minus depreciation.
Actual Cash Value Details
Insurance companies often use the actual cash value of an item to determine the necessary amount of money to give to an insurance claimant. Before we begin to discuss further the term “actual cash value,” first, we need to figure out what “replacement cost” and “depreciation” are referring to. Replacement cost is the amount of money needed to replace an asset like a vehicle, an electronic device, or an estate. To calculate replacement cost, insurance companies usually use the current price of the asset on the market rather than the asset's purchase price.
As for depreciation, it’s a value that represents the asset’s wear and tear incurred from usage over its useful life. To calculate depreciation, accountants usually use one of the common methods that allocate the cost of the asset over its life expectancy. For example, let’s say that a car has an initial cost of $50,000 and a predicted life expectancy of 12 years. In this case, an accountant may depreciate the asset’s value by $3,750 per year. After 12 years, the total amount of the car's depreciation is $45,000 (3,750 * 12). As a side note, the remaining $5,000 becomes the salvage value — the asset’s value when its depreciation is completed.
If we subtract depreciation from replacement cost, we get the actual cash value or the value for which the asset is appraised. In the context of insurance, you can also think of the actual cash value as the value of an asset just before it gets damaged, stolen, or destroyed. When a policyholder suffers the loss of an asset, the insurance coverage may use either actual cash value or replacement cost depending on which coverage option the insurance claimant chose at the start of their policy.
Example of Actual Cash Value
Ricky is a man who purchased a car priced at $50,000 six years ago. Unfortunately, the car recently got stolen when he shopped at a supermarket. To minimize his loss, Ricky, as a policyholder with a car insurance company, wishes to claim the reimbursement for his stolen car. Ricky also knows that the insurance company determines that his car has a useful life of 12 years.
Since Ricky chose actual cash value as the coverage option, the amount of money he will receive should be equal to the real market value of his car just before it gets stolen. Using the straight-line method of depreciation, the insurance company decides that the car has already depreciated by $22,500 ($3,750 X 6) over the course of six years.
Furthermore, even though Ricky’s car price was $50,000 when he purchased it, its current value is only $45,000 at today’s market. Remember, replacement cost uses the current price of the asset instead of the purchase price. Thus, the amount of money Ricky will get for his stolen car is: $45,000 - $22,500 = $22,500.
Actual Cash Value vs. Replacement Cost
A further distinction between these two terms may be necessary as people can easily mistreat actual cash value as replacement cost or vice versa. Most insurance companies offer a choice to either use actual cash value or replacement cost, but one of these plans may cost more than the other. Often, policy holders have to decide between pricier premiums and a higher level of protection, or they have to settle with cheaper payments and a lower level of protection.
With replacement cost, the insurance company will provide enough money to replace the lost asset. As you might have guessed, policyholders often prefer replacement cost since they may receive the full amount of money needed to repurchase the exact same item before it got damaged or stolen. With replacement cost, they don’t need any extra money out of their pocket. That said, insurance companies sometimes divide the payment into two parts: the first part covers the actual cash value, whereas the second part pays the remaining money after the repair has been done.
In different circumstances, policyholders may choose actual cash value since it incurs a cheaper regular payment. The amount of actual cash value should be more or less the same as if the lost item is being sold at a public market. However, since actual cash value won’t provide enough money to replace the damaged asset, it is not as popular as replacement cost.