 Personal Finance Practice Problem using OneNote Cash Value Insurance Payment Calculation Get ready to get financially fit by practicing personal finance OneNote, you're not required to but if you have access and would like to follow along we're in the icon on the left hand side when the Practice Problems tab and the 8020 Cash Value Insurance Payment Calculation tab also take a look at the Immersive Reader Tool Practice Problems will be in the text area too with the same name, same number but with transcripts, transcripts that can be translated into multiple languages and either listened to or read in them focused in on calculating the actual cash value payment that might come from an insurance company if a covered event happens we're imagining that we have cash value insurance coverage as opposed to replacement cost for the coverage and we have furniture that is destroyed in a fire so we're going to imagine that it was covered under the cash value insurance coverage the furniture was five years old it costs to replace the furniture $4,500 the estimated life of it is going to be eight years the original cost what we paid for the furniture we're going to say is $4,000 so we're imagining the furniture has been destroyed imagine like a couch or something like that was destroyed how much are we going to get back from the insurance company if we're talking about the actual cash value as opposed to the replacement cost now remember if we have the replacement cost then we would be thinking about a higher level or quality of insurance because that would be giving us enough money to replace whatever the furniture was say it was a couch or something like that now clearly when we bought the couch it's going to go down in value typically because most stuff does so if we were to replace it even if we bought a comparable couch you would expect that it would be of a higher value even if the couches didn't go up in price and they probably do just due to inflation and so you can't really say that the cost of the couch is per se the current value of the couch and if it was replacement cost then you've got inflation that could be in there as well so if we have the replacement cost then we might be getting simply the 4500 the higher value of the couch or the higher cost of the couch which is most likely higher due to import inflation at this point in time if we've got the replacement cost then not only are we not really trying to take into consideration the inflation per se although we kind of take it into consideration with our calculation but we also have to realize that the fact that the couch has been deteriorated over time so at the point of the loss it's not really worth the replacement cost at that point in time because it's an old couch even if you buy a comparable one so if they give you the replacement cost we got to basically depreciate it in some way if you're familiar with depreciation in accounting it's similar but there's a little bit of a twist to it so we're basically going to do a straight line kind of depreciation to try to determine how much they might pay us if it was the cash value coverage so we're going to say then down here in the calculation we're going to start off with the cost to replace this is the difference between this and say a strictly accounting method if we were using a bookkeeping or accounting method we typically start with the original cost so that's going to be the difference the reason we start with the original cost in accounting is because we're trying to take the cost of the furniture or whatever you know the furniture and allocate it over its useful life so that we expense the cost in the period that we consume it here we're talking about the replacement cost which is the cost to replace it at this point in time so it's a little bit different of an angle or what we're trying to do at this time and that's going to be the major difference between the two calculations so if you're used to accounting note that difference then we've got the estimated life is eight years so we've had it for five years but we're estimating that it could last for eight years where do you get that number? you're probably going to have to talk to the insurance company they're going to have to estimate how long the useful life is going to be and then we're going to divide that out so we're going to take then the 4500 divided by 8 that means it's going to go down by about 563, 562, 50 each year we would expect it's been five years old so I'm going to take that times five years that means it's going to have decreased by the 2008-13 by this point in time so if we take that minus the original cost 4500 you would expect the cash value to be the 1688 clearly the 1688 is substantially lower then we would have to buy a new couch if it was a couch which would be the 4500 which we would have to come up with a difference out of pocket but we'd buy a very cheap couch at that point in time to replace it so that's the difference between the replacement cost which would give us the 4500 which would be great if we were insured with the replacement cost but obviously if it was insured under replacement cost then the insurance premiums you would think would be higher if you've got the cash value you would think the insurance premiums would be lower but if the event happens then they're only going to give you the cash value and then to get you back to the same point you were at with new stuff you'd have to basically pay the difference if you were using the accounting method we would just simply start at the 4000 the useful life still being the 8 years so 4000 that's the cost rather than the replacement value divided by 8 that would be 500 per year if 5 years had passed times 5 years we would say that we had a decline in the value of the 2500 and therefore we'd have the minus the 4000 that would be the 1500 left over the difference between these two calculations being that starting point the replacement cost for the insurance versus the accounting book value using the original cost you could also think about this another way so you might see it calculated if you're looking at people doing these calculations if it was a straight line method like this you could take the cost up top we're back to the insurance calculation you could do a similar thing with accounting if it were a straight line calculation the ratio you could just take the ratio and say okay well I could say that it has an 8 year useful life we've had it for 5 years so I could say 8 minus 5 is 3 years so there's 3 years remaining which haven't been eaten up it hasn't been depreciated to zero it hasn't gone down to a value of zero yet we have 3 years that we would expect that thing to still be living for divided by the total of 8 years there's our ratio which would be 37.5% and if I take the 37.5% times the 4500 which is the replacement cost we get the 1688 so we got the same calculation if I did that same thing down here same thing except I start off with the 4000 we've got the ratio of 3 to 8 3 years remaining compared to the useful life of 8 years there's the 3750 and then if I took that 3750.375 in decibel format times 4000 that would give us the 1500 so you can see it calculated in that format as well so bottom line here we want to know if it's going to be the actual cash value or the replacement cost in the event that an insurable event happens if it's going to be the cash value then we're going to have to take that replacement cost instead of the original cost and then do our calculation to try to figure out what they're going to give us at that point in time which will typically be less than what we would need to replace it and so we got to keep that in mind when we're doing our planning