Every asset is assumed to have a specific life. The value of the asset reduces over its entire life. At the end of the life of the asset, the depreciated value of the asset will be zero. The depreciating policy value is used by insurance companies to assess the reduced asset value for the purpose of insurance premium calculation. Depreciation is the reduction in value of any asset over its life due to wear and tear, usage, damage, and repairs and renovations.
For example, an automobile purchased in 2005 for $50,000 will not realize the original amount invested in a resale transaction. The difference in original purchase price and the realizable value is the depreciation that has taken place. If the asset realizes $10,000, the total reduction in value will be $40,000.
The insured value of any asset is calculated after reducing depreciation from its original value. All insurance companies have a depreciating policy value and calculate the value of asset and the premium chargeable for insuring the same on the basis of this policy.
Depreciation occurs when the asset is used. A vehicle driven over 10,000 miles will not have a brand new engine, tires, transmission, and drive train. Hence, depreciation is inevitable. Reduction in value will occur even if the asset is not used. Natural deterioration of the asset is inevitable. This is why depreciation is called a silent phenomenon.
Depreciation is calculated year after year at an assumed rate. The value of the asset is spread over its life and a specific rate of reduction of value is calculated after considering the nature and type of the asset along with its usage. This rate may vary for different parts of a single asset. The rate of depreciation of tires in the automobile may differ from the rate applied to windshields or the audio system. The depreciated value of electronic items in a house may significantly differ from the depreciated value of the property itself.
Depreciation is calculated using a low, average, and high rate. The high rate is normally applied in the first year. The average rate is applied for subsequent years. Low rate is applied after the asset has been used for a specified number of years.
Depreciation is calculated on the written down value. 20% depreciation on an asset worth $10,000 will be worth $2,000. The value of the asset at the end of the first year will reduce to $8,000. At the end of the 2nd year, the value of the asset will come down by $1,600. The insured value at the end of the 2nd year will be $6,400.