Depletion Allowances in Mining Claims

Article, Insurance DayNovember 2007

Insurance / Property

Tony Levitt takes a look at how depletion charges – initial costs incurred in setting up a mine – can clash with business interruption policies.

When a new mine is first established, the mining house will incur substantial costs before production commences. These may include the cost of the mining, mineral rights, exploration and evaluation costs and stripping and restoration costs. These costs are usually capitalised and are treated as an asset in the financial statements. They are then written off as a proportion of the actual production compared to total expected production over the life of the mine. This writing off of these initial costs is called “depletion”. The term is often misunderstood as it is confused with the depletion or exhaustion of the ore body over the life of the mine.

Accounting treatment

The depletion charge is usually written off in the profit-and-loss account. When there is an interruption to production, the depletion charge will cease for the period during which there is no production. In an insurance claim this could give rise to a saving in the depletion charge.

It will be necessary to analyse the accounting records of the mine to establish whether depletion is treated as a fixed or variable cost in the accounts. If it is treated as a fixed cost it is likely to continue after the loss and no saving will arise but if it is written off based on production then a saving may be appropriate. However, with the depletion costs amortised as the mineral is extracted from the ore body, it is possible that an increase in the amortisation could occur after the interruption to production has ended.

If an incident causes an insured to cease mining for a period of time, it is no longer producing saleable production. Therefore, it may stop the depletion charge through its accounts for that particular mine. This means that the write-off of depletion is deferred to another accounting period but there is no actual saving of the expense, which will have been incurred before the mine started its operations.

A depletion saving in a mining claim, although similar to a depreciation saving at a manufacturing plant, cannot be directly compared. A manufacturing plant cannot be directly compared. A manufacturing asset is depreciated over its useful economic life, which is normally much shorter than that of a mine. Depreciation is based on time rather than production or output and the time period is normally set by convention for example, all equipment may be written off over 10 years, irrespective of its actual useful life.

Also, if equipment is damaged it will usually be replaced at the insurer’s cost, whereas the costs on which the depletion charge is based were initially incurred by the insured and will not be replaced or reimbursed by insurers.

In some cases, depletion is not shown in each mine’s operating accounts, but only in the group’s consolidated accounts. If the depletion is not recorded in the mine’s accounts (the location of the loss), but only in the group accounts, there may be no impact on operating profit of the affected mine even if the depletion charge is reduced. It is also possible that the group’s depletion charge may remain unchanged regardless of the incident.

Where mines have been brought and sold, changes may be made to capital costs to reflect the purchase price and this will affect future depletion charges.
 

Policy

Whether or not a depletion saving is applicable could depend on the wording of the policy, which may provide guidance as to the treatment of costs such as depletion. Another policy consideration is that the ore body itself is often not insured. This in itself may give rise to an argument that a depletion saving cannot be taken as it relates to an uninsured asset.
 

Life of the mine

The depletion of the initial start-up costs begins as soon as production starts. However, at this time the life of the mine, or the proven and probable reserves, may not be known with certainty. Throughout the life of the mine the proven and probable reserves, and thus the estimated life of the mine, will change. As technology advances, or the price of the mineral increases, extraction could become economic in previously uneconomic areas, and both of these factors could increase the life of the mine. Similarly, a reduction in the price of the mineral could shorten the life of the mine. As mining continues, more information is obtained about the ore body which may also impact on the assessment of proven and probable reserves. The longer the life of the mine, the harder it is to estimate its remaining life, and the ore available for extraction.

The life of the mine needs to be viewed in the context of the interruption to production. For example, if the estimated life of the mine is 50 years and the interruption period is only four months, then the impact of the incident in terms of depletion could be small. If this was the case, given the inherent uncertainties with the calculation of the rate of depletion, a saving may not be appropriate. However, it could be different if the remaining life of the mine was a year and the interruption was for six months.

Each situation is different

The potential depletion saving needs to be reviewed on a case-by-case basis as each loss will impact the insured’s business differently. This will apply to the physical impact of the loss on the mine, and the accounting treatment.

In some cases an incident may affect the life of the mine, or the amount of proven and probable reserves. If an incident prevented access to certain areas of the mineral body, the amount of future production against which the capitalised assets are depleted would reduce. Therefore, the depletion charge could increase (on a unit of production basis) for the remainder of the ore body.

The nature of the insured event itself may affect the depletion calculation. If, for example, an insured sustained damage to one of its smelters and continues to mine at full capacity, a depletion saving may not be appropriate as there is no reduction of mining output.

If the insured changed its mine plan or extraction process to mitigate a loss of saleable metal during the indemnity period, this could give rise to a loss of metal through its concentrators to its tailing dams. These mitigating actions may reduce the loss of gross profit during the indemnity period, but the life of the mine may be impacted. Where this is the case, and the insured is writing off depletion over its reserves, it could argue that it had suffered an increased depletion charge. This argument is similar to the use of additional raw material in manufacturing loss, where there may be a loss of yield.
 

Summary

Depletion is often written off based on actual mine production compared to the proven or probable reserves. The reserves are established at a point in time and are likely to change over the life of the mine. Therefore, the depletion written off based on mine production could change for various reasons.

There are a number of factors to consider in determining whether there is a depletion saving following an interruption to production. A detailed consideration of these should determine whether it is appropriate to take the depletion saving into account in calculating the business interruption loss.

 

As appeared in Insurance Day, November 2007.

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