In the early 20th century, most buildings, fixtures and equipment were insured only for their actual cash value (ACV), which reflected the depreciation in value of materials and components over time.
Underwriters were reluctant to offer coverage for the full replacement of property, and did so quite selectively, usually requiring a full appraisal of the property to be insured. To provide the coverage, insurers used what was initially known as “depreciation insurance,”which applied over the ACV coverage and covered the difference between the property’s depreciated ACV and the cost to repair or replace it.
To illustrate, consider a building that would cost $100,000 to build new, but had depreciated 30 percent; the ACV would be 70 percent of the construction cost ($70,000) and the depreciation would be 30 percent ($30,000). In the event of a total loss, the ACV coverage would immediately pay $70,000 — and the depreciation insurance would pay $30,000 when reconstruction was completed.
It’s never been that simple, of course. Even today, with extensive data available on the resilience and durability of building materials and techniques, estimating depreciation is still an inexact science — and the amount of depreciation can vary from one feature to another in the same structure.
Furthermore, the factors for defining actual cash value vary from state to state. According to the law firmTimoney Knox, states look to one of three different factors to determine actual cash value: a property’s fair market value; its replacement cost less depreciation; or the “broad evidence rule”which incorporates consideration of a structure’s condition and marketability, among other factors.
When two different insurers wrote ACV and depreciation coverage separately on the same risk, disputes often arose regarding the extent of depreciation and each carrier’s resulting share of a loss.
Over time, insurance buyers came to see the value of coverage for replacing damaged property beyond its cash value — and insurers responded by combining ACV and depreciation coverage into a single form of loss settlement known as replacement cost coverage. This simplified the coverage and avoided disputes among carriers.