The Number Crunch
Article, Post Magazine – October 2006
Insurance / Property
With the debate on depreciation savings continuing, Tony Levitt of RGL Forensics' London office, sets out his views on this hotly contested area of business interruption claims.
When a fire, flood or explosion destroys plant, equipment or other assets, a company's objective is to rebuild as quickly as possible to save the business. At this time, there is little thought as to how assets will be treated in an insurance claim.
Claims for reconstruction are usually straightforward, in that assets are replaced and a company will be indemnified for the cost of that replacement in accordance with the provisions of the insurance policy - but how are these assets to be treated in the business interruption claim?
When a company buys an asset to use in its business operations, it is shown on the balance sheet at cost. It is then written off - or depreciated - over its expected life. So if, for example, the company bought equipment costing £100,000 that it expects will last for 10 years, then it would depreciate by £10,000 each year.
Consequently, an amount of £10,000 would be written off as depreciation in the income statement each year, thus reducing profits by this amount. The book value of the equipment on the balance sheet would reduce each year - to £90,000 at the end of the first year, £80,000 at the end of the second year, and so on.
Depreciation is the method used to write off assets over their useful life to account for them wearing out over time. So the book value of an asset reflects its written value rather than its actual cash value or the replacement cost of an asset.
If, for example, the company's business is damaged by a fire and equipment is destroyed, then the annual depreciation charge of £10,000 ceases. The equipment no longer exists, so depreciation does not continue and the profit is no longer reduced by this amount.
If a BI claim is made for a loss of gross profit arising from the fire, then insurers will seek to treat the depreciation as a saved cost and it will be deducted from the BI calculation. However, this is often misunderstood.
Depreciation is an accounting entry - not a cash cost - so some commentators argue that a real saving is not made when depreciation ceases. It is compared to a saving in other continuing costs, such as an abatement of rent, which will result in an actual cash saving during the indemnity period. Yet this argument ignores the nature of depreciation, which is to allocate the cost of an asset over its useful life, during which time it will generate revenue for the business.
When an asset is destroyed, it is unable to generate revenue and depreciation ceases. This can be contrasted with the situation where the same piece of equipment is rented instead of being bought outright. If the loss occurred, the rental charge would cease, giving rise to a saving. The impact on a BI claim is, therefore, the same irrespective of the method of financing the equipment.
Back in position
One of the central principles of insurance is to put insureds back in the same position they would have been but for an insured event. This involves indemnifying companies for their loss of profit, not their cash flow. If depreciation is not treated as a saving, then a company will be over-indemnified; it will be reimbursed for the replacement of the asset itself, and its BI claim will include the continuing depreciation cost, even though this has ceased.
If a company replaces its equipment, it is reimbursed for this cost by insurers. Thus, any equipment that was destroyed is, in effect, sold to the insurer for the cost of replacement. The company will show in its books a gain, or profit on disposal, which is the difference between the replacement cost and book value of the equipment.
Often the replacement is at a higher cost than the original equipment. Although insurers are paying for the replacement equipment, it can be argued the company is worse off because it will have to bear a larger amount of depreciation in the future, or that depreciation will continue for a longer time. This argument ignores the gain or profit on disposal of the destroyed equipment, which offsets any potential future increase in the depreciation charge.
Part or whole replacement
If equipment is damaged and is capable of being repaired, the treatment in the BI claim may be different. For example, if the equipment is out of use for a time while it is being repaired but is still in existence, depreciation may continue during the interruption period. If this is the case, it may be incorrect to deduct depreciation as a saving. Similarly, if the equipment is partly destroyed and partly damaged, then the saving in depreciation may depend on the extent of the damage or destruction, and whether the equipment is replaced in whole or in part.
The period for which a saving is calculated is usually taken from the date of destruction until the new equipment is brought into operation. Depreciation of the new equipment will usually commence from this time, and the saving will cease.
The calculation of BI losses will always be subject to the terms and conditions of the policy, and this will apply to the treatment of depreciation as a saving. Nevertheless, the destruction of an asset and its treatment in BI claims will continue to result in debate and argument.
As appeared in Post Magazine, October 2006.