Fire Insurance vs. Machinery Insurance:  Gap in Coverage 

Introduction

In the world of industrial and commercial operations, insurance plays a vital role in safeguarding expensive assets and ensuring business continuity. Two commonly held policies—Fire Insurance and Machinery Insurance—are often considered complementary. However, many policyholders are left surprised, even aggrieved, when their fire damage claims are rejected because the origin of the fire lies within the machinery.

This article explores the distinction between fire and machinery insurance, clarifies the types of perils each covers, and explains why claims often fall into a grey area—leaving businesses vulnerable despite having insurance.

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Distinction between fire insurance and machinery insurance 

In fire insurance, fire is generally understood as hostile fire. 

Furnace heat damage is not regarded as fire damage. Damage due to glowing embers or heated objects not in flame which scorch or burn holes without igniting a fire is not regarded as fire damage. 

A friendly impellent fire is one which remains within a specific confinement area, eg the combustion chamber of a furnace or a gas turbine. Essentially, fire is required to generate heat by means of combustible media (oil, gas or other fuel). Damage does not occur as long as the combustion process remains under control. However, process irregularities may lead to damage such as local overheating in the combustion chamber. Such damage would be excluded from fire policies and falls within the scope of the machinery insurance.

A short circuit can often result in fire and, conversely, a fire can cause a short circuit. The fire policy excludes loss or damage to machines, equipment, electrical conductors resulting from the direct effect of electrical power itself, eg overvoltage, surge voltages, increasing temperatures due to overloading as well as loss or damage to protective devices (safety gear, fuses, etc) occurring during the normal operation of such devices.

Loss or damage due to lightning, however, is covered within the scope of the fire policy.

Fire policy excludes the machine or equipment if it is considered as the source of fire. 

Any resulting fire, loss or damage to other machines or equipment, however, falls within the scope of the fire policy. Fire policy excludes the source of fire.

Loss or damage caused by explosion is covered by the fire policy. Explosion is understood as an instantaneous manifestation of fire, triggered by expanding gases or vapours. 

With respect to pressure vessels (eg steam boilers, cylinders, or vessels for vapour, gas or liquid, or boiling units, steam pipes), explosion damage is deemed to have occurred only if the walls of the receptacle are damaged to such extent that the pressures inside and outside the receptacle are instantaneously equalized. In fire insurance, however, explosion peril does not include distortion, whether or not accompanied by the rupture of any part of the pressure plant caused by crushing stress through forces related to steam or other fluid pressure (apart from the pressure associated with ignited flue gases). 

Furthermore, it does not encompass the destruction of rotating machines caused by centrifugal forces nor loss or damage caused by implosion (instantaneous deformation of a vacuum receptacle caused by external overpressure). Consequently, this loss or damage is not considered to be an explosion in the sense of fire insurance and thus falls within the scope of the machinery insurance. Machinery insurance also provides cover for loss or damage in the case of sudden and violent bursting of pressure plants by internal steam force or other fluid pressure (except pressure of chemical action or of flue gas ignition) causing structural physical displacement of any part of the pressure plant together with forcible ejection of its contents. 

Damage caused by fire preceding or following such events, however, is excluded from machinery cover. 

Understanding the Distinction Between Fire and Machinery Insurance

While both types of insurance protect valuable equipment, they do so under different premises and conditions:

• In Machinery Breakdown (MBD) Insurance, fire or explosion originating internally within the insured machinery is generally covered, while standard fire insurance policies typically exclude such incidents. 
  However, the standard fire policy would cover the resulting spread of fire from the machinery to surrounding property. 
  In simpler terms:
  • MBD policies cover damage to the machine itself from internal fire or explosions.
  • Standard Fire & Special Perils Policies cover damage to surrounding property if the fire started inside a machine and spread outwards. 

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Real-World Example: A Common Source of Grievance

A production machine overheats due to an electrical fault, leading to an internal fire that destroys part of the equipment. The claim is denied under:

• Fire Insurance, because the fire was a result of internal malfunction, not a hostile external fire.

Result: The policyholder is left with an uncovered loss, despite having fire insurance.

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Conclusion

Fire and machinery insurance serve different but complementary purposes. Unfortunately, gaps in understanding—and in coverage—can leave even the most diligent policyholders exposed to costly claims denials.

Reference Publication:© 2000 Swiss Reinsurance Company Zurich Title: Machinery insurance Author: Max Bommeli RE, Reinsurance & Risk division

The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 

 Machinery Insurance on a Reinstatement Value Basis !

Machinery Breakdown (MBD) insurance covers unforeseen and sudden physical damage to machinery, including mechanical and electrical breakdowns, due to various causes like short circuits, faulty materials, and operator negligence. However, it typically excludes damage from events like fire, natural disasters, war, wear and tear, and pre-existing defects. 

Modern machinery is an essential asset in many industries — but it's also a significant investment. A common question from business owners and asset managers is:

"When is the right time to insure machinery for breakdown risk — and for how long — especially if it's under warranty?"

This post dives into that question using insights from engineering reliability (specifically the bathtub curve), warranty timelines, and insurance strategies — all aimed at helping you make informed, cost-effective decisions.

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🔍 Understanding the Machinery Lifecycle: The Bathtub Curve

The bathtub curve is a well-known model used to describe the failure rate of machines over their lifetime:

1. Infant Mortality Phase (0–3 years): Higher failure rates due to early-use issues, manufacturing defects, or installation errors.
2. Useful Life Phase (3–10 years): Lower, stable failure rates — the most reliable period.
3. Wear-Out Phase (10–15 years): Increasing failure rates as components age and wear down.

Understanding this curve is key to aligning your insurance coverage with the machine’s actual risk exposure.

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🔧 The Role of Manufacturer’s Warranty

Most modern machines come with a 1–3 year warranty covering defects, breakdowns, and performance issues. During this period, insurance may overlap with warranty coverage and therefore add unnecessary cost.

That’s why many risk managers choose to delay insurance coverage until after the warranty expires.

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📅 When to Start Machinery Breakdown (MBD) Insurance?

Here’s the practical breakdown:

✅ Start MBD Insurance from Year 3 or on expiry of Warranty period

• This is typically when the warranty ends.
• Failures still occur — and can be costly to repair or replace.
• Machines still hold significant value and are not obsolete.
• Reinstatement value insurance (i.e., new-for-old replacement) is viable and cost-effective.

✅ Insure from Year 3 to Year 10 – The Prime Window

This is the most cost-efficient and operationally relevant window for insurance:

• Breakdown risk is present, even if infrequent.
• Premiums are generally reasonable.
• You can recover full replacement value under reinstatement terms.

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⚠️ What About Year 10–15?

In this phase:

• Machines may be approaching obsolescence.
• Insurers may tighten coverage (e.g., condition surveys, exclusions).
• Premiums increase, but payout terms might change.

Recommendation:
 Continue coverage if the machine is mission-critical or difficult to replace. Consider:

• Switching to indemnity-based cover (market value).
• Building a self-insurance reserve for predictable wear-and-tear failures.

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📊 Summary Table – Insurance Timing Strategy

Machine Age (Years)	Recommended Action	Why?
0–3	❌ No insurance	Covered under warranty; avoid double coverage.
3–10	✅ Insure (Reinstatement Basis)	Prime period for cost-effective protection.
10–13	⚠️ Optional – Case by case	Depends on criticality, condition, and premium cost.
13–15	❌ Consider ending cover or switch to market value	Reinstatement basis often no longer viable.

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🧭 Final Thoughts

Machinery Breakdown Insurance on a Reinstatement Value basis makes the most sense from Year 3 to Year 10 — when breakdowns can still be financially disruptive, and the machines are worth replacing like-for-like.

After Year 10, decisions should be based on operational importance, replacement planning, and insurer terms. Aligning insurance with your asset’s lifecycle ensures you’re not overspending on unnecessary cover — or leaving your operations exposed.

The above interpretation is absolutely personal in nature and is not binding on any individual or organisation in particular.

 Important Role of Insurance Valuation in Assessing Business Health

During assignment for Insurance valuations of fixed assets on re-instatement basis, usually clients ask for report on market valuation basis as well to know the current worth of their business.

In addition, the periodical market value/depreciated replacement cost valuation may be helpful in understanding a company’s overall financial health also for the business owners.

During preparation for ‘Plant and Machinery Valuation certification’, came across the following very important publication, which in my view will be very helpful in understanding the concept presented here:

 STANDARDS ON VALUATION OF PLANT, MACHINERY AND EQUIPMENT, Prepared by CVSRTA Registered Valuers Association & Centre for Valuation Studies, Research & Training Association

In the practical world of business operations—: comprehensive valuations are time-consuming, costly, and require complex inputs that may not be readily available or justifiable outside of key strategic events such as mergers, acquisitions, or financing rounds.

In this context, insurance valuation may offer a more practical and cost-effective alternative that can still serve as a meaningful indicator of business health.

Unlike full enterprise valuation, which attempts to capture the total worth of a business based on future cash flows, market comparables, insurance indemnity valuation focuses on the market (DCR) value of physical and tangible assets. While more limited in scope, this approach may provide insights into the present economic condition of the business, especially when done periodically.

One of the significant advantages of insurance valuation (Depreciated Replacement Cost basis) is that it can be utilized for finding economic obsolescence—a critical element in asset-heavy businesses.

“Economic obsolescence exists, if the economic support for fixed and intangible assets is less than the fractional values of the identified assets, as individually estimated by the depreciated replacement cost or sales comparison methods, as the case may be.

Business enterprise value less net working capital represents the economic support for fixed and intangible assets.

Share Holder’s Equity + Long Term Debt = Net Working Capital (Current Assets - Current Liabilities) + Fixed Assets + Intangible Assets

Followings are readily available from company’s financial reports for the necessary deduction

CA = Current assets

FA = Fixed Assets

IA = Intangible Assets

CL = Current liabilities

 LTD = Long-term debt

SE = Stockholders’ equity

If there is excess economic support for the underlying identified assets, it is concluded that unidentified intangible value exists, which is generally considered to be goodwill or going concern value. 

Once economic obsolescence is suspected, a full business valuation may be initiated with the help of specialist Chartered Accountants and remedial measures undertaken.

In essence, while insurance valuation is not a replacement for full enterprise appraisal, it offers a fair and objective framework for monitoring key indicators of business health. Its periodic execution aligns better with operational realities and can serve as a proactive tool for risk management, strategic planning, and resource optimization.

Important Caveat: It's an Indicator, Not a Substitute

Of course, a DRC-based valuation is not a replacement for a Sales Comparison or full-blown income approach. It doesn’t factor in future cash flows, competitive dynamics, or goodwill. But as a practical, cost-effective tool for interim business checks at the time of insurance policy renewals, it may offer additional utility.

In summary: Think of DRC-based insurance valuations not just as a risk management necessity, but also as a financial wellness tool. When interpreted smartly, they can spotlight trends in obsolescence, underline capital misallocations, and even hint at business’s ability to generate value in today’s economy.

Reference Publication:

STANDARDS ON VALUATION OF PLANT, MACHINERY AND EQUIPMENT, Prepared by CVSRTA Registered Valuers Association & Centre for Valuation Studies, Research & Training Association.

The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 Title: Predicting Equipment Resale Value: A Handy Guide for Indian Contractors

When it comes to heavy construction machinery, knowing when to sell can be just as important as knowing what to buy. For many contractors, this boils down to one key question: “How much will my machine be worth after a few years of use?”

Drawing inspiration from a publication by Dr. Gunnar Lucko at Virginia Tech, here's how Indian contractors can make smarter decisions using data, not guesswork.

🏗️ Case in Point: JCB 3DX Backhoe Loader

A regional road contractor in Maharashtra purchased a JCB 3DX backhoe loader in 2018 for ₹32 lakhs. After 7 years of operation, here's the financial picture:

• Fuel cost: ~₹34 lakhs (based on 1,200 hrs/year @ ₹90/litre)

• Maintenance cost: ~₹6.5 lakhs

• Estimated resale value (2025): ₹18.5 lakhs (58% of purchase price)

• Projected value in 2028: ₹11.2 lakhs (35% of purchase price)

Net cost of ownership (7 years): ₹54 lakhs

🧮 Dr. Lucko used statistical modeling to calculate optimal resale timing by factoring in:

• Age and condition of the machine

• Manufacturer brand perception

• Regional auction trends

• Macroeconomic indicators (like inflation and GDP growth)

🔄 Smart Decision: Sell Now or Wait?

For this contractor, selling now brings a better return, avoids rapid depreciation, and allows investment in an upgraded model like the JCB 3DX Super or CAT 424 4WD, both offering better fuel efficiency and higher resale value down the line.

💡 Final Thoughts

Most site managers don’t have time for spreadsheets and regression curves. But even a simple understanding of how resale values behave can:

• Strengthen your bids

• Reduce total owning cost

• Improve fleet planning

If you're interested in a free Residual Value Estimator sheet tailored to Indian machines, drop a comment below or reach out!

Author’s Reflection > > During my years on construction sites, I often saw valuable machines—graders, backhoe loaders, dumpers—left idle in the yard for weeks, sometimes months. Repairs delayed. Spare parts unavailable. Maintenance teams scrambling, sometimes forced to cannibalize components from older machines just to keep newer ones running. > > These hard-earned observations shaped my perspective on how critical equipment lifecycle planning really is. > > This article was created with the support of Microsoft Copilot—helping translate complex financial models into practical insights for those who keep our infrastructure moving, often against all odds.

The above is my personal interpretation on the subject and has been composed with help of Google Copilot.

 

Title: Repair, Replace or Discard? Understanding the Real Value Behind Your Assets

We all have that one favorite item—a watch gifted years ago, a handbag we carry everywhere, or an old kitchen appliance that has served us loyally. When these items start to wear out or malfunction, we’re faced with a decision: Should we repair it or replace/discard it?

This decision, surprisingly, isn't always made on sound financial logic. More often, it’s driven by emotion and habit. And that’s where we go wrong.

Let me give you two real-life examples from my own experience.

My wife recently spent ₹1,000 to repair a wristwatch whose purchase price was around ₹700. In another instance, she was willing to spend ₹300 on fixing a handbag that originally costed her ₹300—and has already seen years of use. Her reasoning? “I like it.”

I couldn’t help but reflect on how such decisions ignore some basic—but crucial—principles of asset valuation.

Rational repair/ replacement /discard decision is much more crucial in business environments, where the financial stakes are much higher. 

Many Industrialists reluctant to let go their aged old non-functional equipment insure these separately as obsolete assets in their property insurance policies. 

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Emotional Attachments vs Economic Value

We tend to form emotional bonds with our possessions. That’s human. But when it comes to spending money, especially on repairs, emotion can cloud rational judgment.

The economic value of an asset is not the same as its original purchase price. As time passes, most items depreciate—they lose value due to wear and tear, obsolescence, or simply changes in taste and utility.

The Three Pillars of Repair Decisions

When considering whether to repair an asset, we should ideally evaluate:

1. Current Market Value (CMV)
   What is the item worth today, if you tried to sell it?
2. Residual Value (RV)
   What is the item expected to be worth at the end of its useful life?
3. Remaining Useful Life (RUL)
   How much longer can the asset realistically serve its intended purpose after repair?

Now apply this to any repair decision:
If the cost of repair exceeds the CMV, and the RUL is short, the repair is likely not justified—financially speaking.

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A Simple Rule of Thumb

A good benchmark to use:

Repair cost should not exceed 50% of the item’s current market value, unless the item has a long remaining useful life or exceptional utility.

Of course, there are exceptions. Heirlooms, sentimental gifts, or rare collectibles may warrant a different approach. But for everyday items, this logic helps prevent throwing good money after bad.

How to Think Like a Valuer

Before making your next repair decision, pause and ask:

• How old is the item?
• What is its resale value today?
• How long can it continue working effectively?
• Is the cost of repair proportionate to its value and future service potential?

This mindset shift can lead to smarter financial decisions and better resource allocation—not to mention less clutter and fewer regrets.

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Conclusion

Valuation is not just for accountants, insurers, or investors. It’s a life skill. Whether it’s a ₹700 watch or a ₹30 lakh machine, we must learn to separate emotional worth from economic value.

Let’s be rational where it matters—and reserve our sentiment for things that truly deserve it.

The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 

 Can Fire in Cotton Bales be treated as Spontaneous Combustion:

Cotton bales covered under the Standard Fire and Special Perils (SFSP) policy are stored in covered warehouses without any electrical cabling inside.

"Often, in the event of a fire, representatives of the insured often attempt—out of both ignorance and sincerity—to prove that the cause was spontaneous combustion."

Standard fire and special perils policy does not cover spontaneous combustion, which is an ‘add on’ in fire insurance.

Cotton is assigned to Class 4.1 of the IMDG Code (Flammable solids) and not a spontaneously combustible material.

 Cotton fires often begin as smoldering fires, which can burn internally for extended periods before erupting into flames. This can make it difficult to detect the fire until it's well-established. The considerable compression prevents the fire from spreading as quickly as it would spread through uncompressed bales.

However Specific characteristics and negative external influences may cause cotton bales to behave like a substance from Class 4.2 (Substances liable to spontaneous combustion) of the IMDG Code.

Self-heating / Spontaneous combustion

Cotton bales can spontaneously combust due to various factors, including dampness, oil contamination, and improper storage, leading to smoldering and eventual fire. The tight packing of cotton within bales allows for internal heat buildup, particularly when damp or oily, which can lead to ignition. 

• Dampness:

When cotton is pressed or baled in a damp state, it can generate heat internally, especially if the moisture content is high and the heat cannot dissipate. This heat buildup can eventually reach the ignition temperature, leading to spontaneous combustion. 

• Oil Contamination:

The presence of oils, even in small amounts, can significantly increase the flammability of cotton and lower the temperature at which it can spontaneously ignite. 

• Improper Storage:

Stacking bales too high, inadequate ventilation, or improper spacing can contribute to heat buildup and the risk of spontaneous combustion. 

• Microbial Activity:

Microbes can grow and reproduce in damp cotton, generating heat as a byproduct of their activity, which can further contribute to the risk of spontaneous combustion. 

Spontaneous Combustible Materials

The following materials should preferably be notified to insurer and covered as ‘add on’ in fire insurance policy.

The following materials can be subdivided based on their propensity to spontaneously:

(Reference: sovereigninsurance.ca)

Strong Propensity: Charcoal • Cod liver oil • Fish oil • Fishmeal • Fish waste • Linseed oil • Clothing, silk, fabrics and rags soaked with oil • Tung nut flour (or tung, or Chinese wood) • Peanut seed coat (skin covering the peanut, under the shell) • Pigments in Oil • Cornmeal based pet food

Average Propensity: •Food for animals • Foam rubber • Certain metallic powders • Bituminous coal • Fertilizers • Hay • Coconut bark • Manure Distillery or brewery beans • Whale oil • Cottonseed oil • Corn oil • Menhaden oil • Perilla oil • Pine oil • Soybean oil • Tung oil (or tung oil, or Chinese wood) • Red oil (unrefined palm oil) • Roofing papers and felts • Paint containing drying oils • Pyrite • Rubber residue • Wool residue • Paper waste

Low Propensity: •Cotton seeds • Mustard oil • Palm oil • Peanut oil • Turpentine

The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 

EFFECTIVE LIFE & REMAINING USEFUL LIFE OF PLANT & MACHINERY

To determine the effective life and remaining useful life of plant and machinery, one needs to consider the asset's physical condition, operational performance, and the applicable depreciation methods. The effective life is the period during which the asset is expected to be used productively, while the remaining useful life is the estimated period from the current date until the asset is no longer expected to be used. 

1. Understanding Effective Life:

Effective life refers to the period an asset is expected to be used productively, considering factors like physical condition, technological advancements, and operational performance. It's a more practical estimate than the legal or statutory useful life, which may be specified in accounting standards or tax regulations.

2. Factors Affecting Effective Life:

• Physical Condition: Regular maintenance, wear and tear, and potential damage can impact an asset's physical condition and, consequently, its effective life.

• Technological Advancements: New technologies and innovations may render older equipment obsolete, shortening its effective life.

• Operational Performance: How an asset is used, the frequency of use, and the intensity of operations can affect its effective life.

3. Determining Effective Life:

• Historical Data: Analyze past maintenance costs, repair records, and production data to assess the asset's historical performance and predict its future performance.

• Manufacturer's Specifications: Consult the manufacturer's recommendations for maintenance schedules and expected lifespan.

• Expert Opinion: Seek professional advice from engineers, valuers, or other experts familiar with the specific type of plant and machinery.

4. Remaining Useful Life:

The remaining useful life is the estimated period from the current date to when the asset is expected to be retired or no longer used. It's calculated by subtracting the asset's age from its effective life.

5. Importance of Accurate Determination:

• Depreciation: The remaining useful life is crucial for calculating depreciation, which affects a company's financial statements and tax obligations.

• Maintenance and Replacement Planning: Accurate estimates of effective and remaining useful life help in planning maintenance schedules and replacement cycles, optimizing asset utilization and minimizing costs.

• Asset Management: Knowing the remaining useful life of assets enables businesses to make informed decisions about their asset management strategy, such as whether to upgrade, refurbish, or retire an asset.

6.       Documentation:

It's important to document the methods and calculations used to determine effective life and remaining useful life for transparency and also for insurance claim purposes.

7.            Regular Review:

The effective life and remaining useful life should be reviewed regularly to ensure they remain accurate and up-to-date, especially in light of changes in technology, operating conditions, and maintenance practices. 

The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular. 

 

Depreciation due to Deterioration of Plants & Machines

Depreciation It is the usual wear and tear caused by the normal working of any asset, its use is liable to a certain amount of deterioration despite the care and attention bestowed on its maintenance and preservation.

Physical depreciation is broken down into curable and incurable

Curable Depreciation

The following input for machinery under consideration by technical personnel of clients helps in estimating curable depreciation.

(i) Did the equipment undergo major repair or reconditioning?

(ii) Did the equipment undergo capability test?

(iii) What is the present condition in terms of production rate and accuracy vis-à-vis the original at the time of purchase?

Curable depreciation is fixable by refurbishing, rebuilding of the equipment

Physical Incurable Depreciation

Physical depreciation is caused from age, wear and tear, fatigue, exposure to the elements or lack of maintenance. Overall physical depreciation is caused more by use rather than age.

A visual inspection can help to assess present condition of the machine

General Upkeep:

If an equipment is well-maintained during its service life and is expected to operate longer with lower costs, its value may be higher than expected for a machine of its age.

Dirt, dust, and other contaminants can interfere with lubrication and cause abrasive wear on the surfaces of the rotating equipment. This can also lead to increased friction, leading to increased heat, and damage to seals, bearings, and other components. Contamination can also lead to corrosion and oxidation, which can cause parts to degrade and fail prematurely. Additionally, contaminants can interfere with the flow of fluids, cause bearing failure, cause pressure spikes, block lubricant pathways, and reduce equipment efficiency.

Observed deterioration (also known as the 0 – 100% method)

 Lump sum figure of depreciation can be adopted as given below:

 Condition                                                        Depreciation %

New (N)                                                            0 - 5

Excellent (E)                                                    6 - 10

Very Good (VG)                                              11 - 20

Good (G)                                                         21 - 50

Fair (F)                                                            51 - 70

Poor (P)                                                           71 - 90

Scrap (S)                                                          91 - 100

If upkeep and maintenance are high, then the effective age will be lower than the actual age and conversely if upkeep and maintenance have been low then the effective age will be greater than the actual age.

As one of the important obsolescence factors considered by the cost approach, physical deterioration influences the conclusion of value.

Reference Document: STANDARDS ON VALUATION OF PLANT, MACHINERY AND EQUIPMENT; Publisher: Centre for Valuation Studies, Research & Training Association, India

 The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 

Taking benefit of Insurance Valuation for Asset Management

Fixed assets represent the largest item on Company's insurance budget– especially in capital-intensive industries like manufacturing, power generation, oil & gas.

While completing a property insurance appraisal, the findings can also be useful for fixed asset management as both require a physical inspection of the fixed assets inventory.

When it comes to insurable values, accuracy is vital to avoid excess insurance premiums on ghost assets.

An insurance appraisal will consider a total replacement cost of all the fixed assets and buildings. This would also include expensed assets below the capitalization threshold.

The purpose of an asset management system, or asset system, is to keep track of the equipment and inventory vital to the day-to-day operation of the business.

The only reliable way to verify and validate the fixed asset information is to conduct a physical inventory. Eliminate assets those have been lost, stolen, or unusable but are still listed as an active fixed asset in the system and also inclusion of new assets upon purchase

From insurance point of view, this means their balance sheets match up with their records, and assets that have been loaned, lost or stolen are timely identified and excluded from insurance premium. Companies not effectively managing their assets typically lose considerable amounts of time and money.

Without an accurate, real-time, organized system for tracking assets, it will be difficult to plan timely preventive maintenance of the important machines.

The benefits of an asset management system include :

·        To track and manage an asset’s entire lifecycle, from initial acquisition to periodic maintenance to phase-out from inventory

• To monitor asset use and make improvements.
• to implement preventive maintenance and routine inspections, thereby preventing expensive repairs and downtime.
• To maximize equipment lifecycles and staving off early replacements
• Reduced waste and increased profitability
• In obtaining better residual value while selling off machines due to functional or economical obsolescence

An asset management record may contain details like purchase date, serial number, manufacturer, model, lifecycle cost including maintenance and repair, present value, number of each type of fixed asset, locations, and estimated lifespans.

Such record provides a picture of the present conditions of the machineries and also help companies prepare for the future. Based on facts, they can make decisions about the assets they will need in the coming year. Subsequently, they can avoid under or over-stocking assets and manage their resources responsibly. Asset management optimizes an asset's operational performance during its lifespan and aims to keep these assets running profitably for as long as possible.

The decision to repair or replace an asset depends upon various factors, including the type of asset, age, wear and tear, and role in the production line. To decide between repairing and replacing an asset, a management company must compare its current value and the repair costs. If repair costs are less than the value of equipment, it is best to get it repaired. However, when the repair costs exceed the value of equipment, it is better to replace it.

 The above interpretations are absolutely personal in nature and are not binding on any individual/ organization in particular.

 

CONCEPT OF DEPRECIATION IN INSURANCE VALUATION

The following paragraphs are being reproduced from the Book: CONCEPT OF DEPRECIATION IN INSURANCE VALUATION, which may be valuable for fixing residual life of the insured fixed assets.

Although I tried my best to recover the source/origin of this publication, I could not trace this so far. However I find the concept very useful while assessing old but satisfactorily usable machines, 

"The depreciation being provided by the Insured in his books of account in line with what is permissible under Income Tax regulations, need not necessarily be considered as an appropriate basis for computing the insurable value of capital assets.

Insurance is concerned with actual intrinsic loss of useful working life deducted due to real wear and tear, and not the notional amounts deducted from the reducing balances, for the purpose of Income Tax and Balance Sheets.

Maximum Depreciation: (Residual Value concept)

Suppose a machine is 18 years old and is still giving satisfactory performance and almost the rated output. Assuming that we ascribe a life of 20 years to this machine, the total depreciation will touch 90%, at 5% per year. This is not fair if the machine is still giving satisfactory production, because of good maintenance. In such case, where it can be established that the standard of maintenance is good, it is enough if the maximum depreciation is levelled off at 75%. Thereafter, the ‘Residual Value Concept’ will take over.

Surely, after 15 years, when we reach a total depreciation of 75%, the machine is not a mere scrap. If it is still working well, it will at-least have a ‘Residual Value’ of 25% applied on its present replacement cost.

In some industries including all Petro-Chemical complex, where very high standard of renewals and maintenance is a must for safe operation of the plant; where there is a full fledged maintenance department, staffed with qualified engineers; where regular periodical maintenance shutdowns are taken to completely overhaul and check the entire Plant and Machinery; where the industry concerned maintains adequate spares to replace worn out items as and when needed – in such cases, it has to be conceded that the Plant is in excellent condition at all times; depreciation could be at a lower level provided there is satisfactory evidence of such a high standard of maintenance.

However, where it is evident that the Plant and Machinery have been ‘worked to death’ they are in a highly worn out condition with no renewals/replacements having been carried out as per maintenance norms then the maximum depreciation can be taken even upto 95%; the balance 5% representing practically the ‘Scrap Value’ of the machinery.

In the case of nonworking obsolete old machines lying in the factory, their value should be worked out only on the basis of their weight as metal scrap.

It will be seen from the above that, unless the valuation and depreciation exercises are carried out appropriately, serious distortions will result. The escalation and depreciation formulae shown in the above two tables should not be followed blindly for all cases.

Wherever they are found unsuitable necessary modifications should be made suitably.

In the case of capital assets other than plant and machinery, such as furniture, fixtures, office equipment, the same consideration as explained above would normally apply.

The depreciation being provided by the Insured in his books of account in line with what is permissible under Income Tax regulations, need out necessarily be considered as an appropriate basis for computing the insurable value of capital assets.

Insurance is concerned with actual intrinsic loss of useful working life of a deducted due to real wear and tear, and not the notional amounts deducted from the reducing balances, for the purpose of Income Tax and Balance Sheets.

Maximum Depreciation : (Residual Value concept)

Suppose a machine is 18 years old and is still giving satisfactory performance and almost the rated output. Assuming that we ascribe a life of 20 years to this machine, the total depreciation will touch 90%, at 5% per year. This is not fair if the machine is still giving satisfactory production, because of good maintenance. In such case, where it can be established that the standard of maintenance is good, it is enough if the maximum depreciation is levelled off at 75%. Thereafter, the ‘Residual Value Concept’ will take over.

Surely, after 15 years, when we reach a total depreciation of 75%, the machine is not a mere scrap. If it is still working well, it will at-least have a ‘Residual Value’ of 25% applied on its present replacement cost.

In some industries including all Petro-Chemical complex, where very high standard of renewals and maintenance is a must for safe operation of the plant; where there is a full fledged maintenance department, staffed with qualified engineers; where regular periodical maintenance shutdowns are taken to completely overhaul and check the entire Plant and Machinery; where the industry concerned maintains adequate spares to replace worn out items as and when needed – in such cases, it has to be conceded that the Plant is in excellent condition at all times; depreciation could be at a lower level provided there is satisfactory evidence of such a high standard of maintenance.

However, where it is evident that the Plant and Machinery have been ‘worked to death’ they are in a highly worn out condition with no renewals/replacements having been carried out as per maintenance norms then the maximum depreciation can be taken even upto 95%; the balance 5% representing practically the ‘Scrap Value’ of the machinery.

In the case of nonworking obsolete old machines lying in the factory, their value should be worked out only on the basis of their weight as metal scrap.

It will be seen from the above that, unless the valuation and depreciation exercises are carried out appropriately, serious distortions will result. The escalation and depreciation formulae shown in the above two tables should not be followed blindly for all cases.

Wherever they are found unsuitable necessary modifications should be made suitably.

In the case of capital assets other than plant and machinery, such as furniture, fixtures, office equipment, the same consideration as explained above would normally apply".

The publication has not been originated by me. I have come across this publication while undergoing self-study sessions for IBBI Valuation Examination.

Above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular. 

 

Why Plant & Machinery Valuation Matters:

Followings are the reasons why plants and machineries are needed to be appraised periodically:

1. Financial Reporting:

Accurate valuation ensures that assets are reported correctly on the balance sheet, impacting depreciation, taxation, and overall financial health. 

2.               2    Insurance and Risk Management:

Accurate machinery and equipment appraisal assists in reducing any financial losses. It eliminates the impact of loss or theft by enabling to secure sufficient insurance coverage for plant & equipment.

Furthermore, knowing the depreciation rate of assets enables to anticipate their declining value and plan accordingly, reducing the financial burden of future replacements.

3. Investment Decisions:

Valuations are essential for making informed decisions about investments, acquisitions, and disposals of machinery. Accurate valuations enable to make informed choices when buying or selling equipment. Knowing their true market value will help negotiate the best price. 

4. Fundraising:

Accurate valuations are crucial for securing loans or attracting investors, as lenders and investors rely on the value of assets as collateral. 

5. Mergers and Acquisitions:

Valuations are vital in determining the fair market value of machinery during mergers and acquisitions. 

6. Asset Management:

By understanding the value of machinery, companies can optimize its utilization, maintenance, and replacement, maximizing return on investment. By tracking the value of assets over time, one can monitor their performance and make informed decisions about their economic lifespan and replacement. 

This allows to maximize the return on investment of machinery and equipment while ensuring their continued functionality and productivity.

Note: Point 1, 4 &5 are better to be left on Company’s Chartered Accountants.

 

The above interpretations are absolutely personal in nature and are not binding on any individual/ organization in particular.

 

INSURANCE OF CNC MACHINES UNDER ELECTRONIC EQUIPMENTS INSURANCE

CNC machines & machining centers are widely used for precision machining of automotive and other engineering components. These machines are generally covered under Machinery Insurance policies for sudden unforeseen breakdowns.

Option to insure under either MB or EEI Policy

CNC Machines preferably should be insured under EEI Policy as EEI provides much wider coverage in comparison with MB Policy

Note – Where it is not feasible to give a breakup of values for minor electronic equipment (non-metallic items) which were integral to various machines, eg CNC Machines, wherever such CNC Machines are insured, the Insured can have option to cover the same either under MB or EEI policy.

In India, a CNC machine, due to its significant electronic components, is typically covered under an Electronic Equipment Insurance (EEI) policy rather than a standard Machinery Breakdown (MB) policy, meaning it should be included in your EEI coverage to ensure protection against damages or breakdowns related to its electronic parts and systems. 

All Electronic equipment like Computers, Medical, Biomedical, Micro- processors; Audio/Visual equipment including the value of Systems Software may be covered under Electronic Equipment Policy. The term equipment shall also include the entire computer system consisting of CPU, Keyboards, Monitors, Printers, Stabilizers, UPS, System Software etc.

Cover granted under E.E.I policy are virtually against all insurable perils namely fire, RSMD, Terrorism, Flood, Storm, subsidence, Earthquake, accidental breakdown while at work or rest, electrical damage, faulty manipulation, dropping, falling impact etc.

OTHER FEATURES: If the insured want to opt out fire and allied perils cover, a premium reduction in rate is offered based on the coverage.

SUM INSURED: Sum Insured shall be equal to the cost of replacement of the insured property by new property of the same kind and same capacity, which shall mean its replacement cost including freight dues and customs duties, if any and erection costs. The sum insured of the equipment insured under this section shall include the value of ‘System Software’.

PROHIBITION TO ISSUE MB POLICY ON ELECTRONIC EQUIPMENT- Unless otherwise specifically provided for in MB Guide Rate, no machinery breakdown policy should be issued on Electronic Equipment like Computers, Medical, Bio-medical, Micro processors, Audio-visual equipment which must be covered under EEI Policy only.

Loss or damage sustained during transit and any loss/damage attributable to transit shall be excluded under both Machinery Breakdown and Electronic Equipment Policy

An Electronic Equipment Insurance (EEI) policy in India would cover an industrial CNC machine against a wide range of damages, including electrical breakdowns, mechanical failures, fire, theft, accidental damage, and even damage caused by faulty operation, essentially providing comprehensive protection for the machine's functionality due to unforeseen events; the key is to ensure the CNC machine is specifically listed as covered under the EEI policy. 

Key points about CNC machine coverage under EEI:

• Specific coverage:

EEI policies generally cover damages caused by electrical surges, short circuits, faulty operations, accidental impacts, fire, theft, and natural calamities to the electronic components of a CNC machine. 

• Separate policy needed:

While some minor electronic parts integrated into a standard machine might be covered under an MB policy, for comprehensive protection of a CNC machine, a dedicated EEI policy is recommended. 

• Consult with insurer:

Always check with insurance provider to clarify the exact coverage details for specific CNC machine to ensure it is appropriately included within the EEI policy. 

The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 

Valuation of Tangible Fixed Assets For Insurance Purpose:

Tangible fixed assets are long-term assets with a physical presence that are held by a company to support its operations and generate economic benefits over multiple accounting periods. These assets are not intended for sale in the ordinary course of business

For insurance coverage, accurate valuation of tangible fixed assets need consideration for depreciation, potential obsolescence, and the need for repair or replacement option in the event of a damage.

Valuation of tangible fixed assets assists in determining insurance coverage and replacement costs, ensuring proper risk management and asset protection.

There are two methods of Fire insurance coverage in India for determining the appropriate value of a loss under commercial fire insurance.

1.     Indemnity: best described as compensation for a loss sustained, and all contracts of property insurance are referred to as contracts of indemnity.

The intension of a party to the contract is that the insured, on the happening of an insured event, will be placed by the insurer, in the same pecuniary position that the insured occupied immediately before the event. This is subject to any limitations which may have been agreed and written into the contract!

Replacing "like for like”

In other words, if an item of equipment which was 5 years old was damaged beyond repair insurers would be liable to indemnify the insured based on the value of an item of a similar age and condition. Depreciation will be considered.

An important point to note that balance useful life calculation for depreciation calculation of the insured property may significantly differ from that of financial reporting standard. 

2.     Reinstatement Value Condition Clause:

Reinstatement cost, often termed as the 'replacement cost', an alternative method of settlement, refers to the amount of money needed to rebuild or restore a property back to its original state after it has been damaged or destroyed, without considering its age or condition prior to the damage. In other words depreciation is not considered in the claim value calculation.

Reinstatement value claims are only valid if the damaged property has been repaired or replaced. The sum insured depends on the replacement value of the damaged property or asset.

Re-instatement Cost Method:

Apart from Fire insurance, Sum insurance for Engineering Insurance policies like Machinery Insurance, Electronic Equipment Insurance, Contractor’s Plant & Machinery Insurances are mandatorily R.I Value based.

The valuation of tangible fixed assets using the reinstatement cost method involves determining the value of an asset based on the cost of replacing it with a similar new asset at current market prices. This approach assumes that the value of an asset is equivalent to the cost of acquiring or constructing a new asset of similar utility.

The replacement cost method is particularly useful when the asset being valued is unique or custom-built and does not have readily available market comparable. R.I. basis of valuation provides insights into the costs of replacing the assets and helps businesses understand the potential investment required to obtain a similar asset.

An insurance reinstatement value assessment is totally independent of the market value of a property.

 Valuation Process

The process typically begins with identifying the specific assets to be valued and gathering relevant information such as purchase records, maintenance history, and any appraisals or assessments previously conducted, and type of insurance policy needed.

The frequency of performing valuations of tangible fixed assets varies depends on several factors. Generally, it is recommended for companies to conduct valuations periodically or whenever significant changes occur, such as acquisitions, disposals, or major capital investments.

Valuing tangible fixed assets can pose several challenges. One common challenge is determining an accurate indemnity/fair market value, especially for unique or specialized assets with limited comparable market data.

Assessing depreciation and obsolescence accurately can also be challenging, as it requires a thorough understanding of the asset’s condition, usage, useful life, and technological advancements.

Additionally, valuation challenges may also arise from changing market conditions, inflation, economic uncertainties, or discrepancies in data availability.

Higher valuations may result in increased insurance premium while lower results in inadequate coverage for the assets in case of any mishap.

The above interpretation is absolutely personal in nature and is not binding on any individual/ organization in particular

 

Measure of Betterment in Reinstatement Basis of Claim Settlement

When dealing with commercial property claims most often the basis of settlement is reinstatement. is important the issues related to betterment are understood.

A contract of fire insurance is fundamentally one of indemnity, since its object is to make good, within the limits of the amount of insurance, and subject to terms and conditions of the policy, the actual loss sustained and nothing more.

An insurance policy providing reinstatement cover is basically a contract of indemnity. The addition of the reinstatement basis of settlement provides a means by which an indemnity will be calculated.

By definition, ‘Reinstatement value’ is the cost necessary to replace, repair, or rebuild the insured property to a condition substantially the same as, but not better or more extensive than, its condition when new provided the reinstatement is actually carried out.

In other words, damaged / destroyed / irreparable property to be replaced by new property of “the same kind or type but not superior to or more extensive than the insured property” and the monetary claim to be allowed on value as new basis without deducting depreciation.

An insurance policy covers the insured’s financial interest in the subject matter of the cover, not the item itself. So, if the damage to the item in question causes the insured no financial loss, there is no indemnity to consider, and reinstatement is an irrelevance.

Policy does not only insure property itself, but also the insured’s interest in the property and measurement of loss is the extent of such interest in property damaged or destroyed by an insured peril.

If a warehouse is destroyed, a building of modern steel frame may cost less to construct in comparison with the old one with brick walls and internal columns construction. By reinstating the property using modern methods, the insured’s financial interest is protected as the final result is an asset at least as valuable with equal utility than that which was lost.

In a situation where rectification works have improved a property or asset in some way (i.e. it is larger, newer or has an improved specification), the insurer will often claim that betterment has been obtained and that a deduction should be made in any award of damages.

There are three common examples of financial benefit obtained following rectification: -

·        The property or asset is improved, either because the replacement specification is enhanced,

·        The available products are superior, or

·        The lifecycle and maintenance requirements are improved.

For an award of damages to be reduced for betterment it is necessary to show that the claimant has received some form of financial benefit or advantage.

This same principle applies to machinery and contents – the insured’s financial interest in an item is whatever it does, not the machine itself.

Computers may be an excellent example, given the fact that new equipment is generally better and cheaper than the original. It would seem impractical to spend money on procuring an out-of-date specification of computer when, for far less, a more efficient and faster computer can be obtained. today.

It is the functionality that is important, but that can of course include reliability, quality and the like as all these things are relevant.

The basic principle remains however that the machine is the current equivalent in terms of its functionality – same capacity, output, quality of product, etc. as the original.

Comparison has to be made between the latest and the old machinery with regard to following aspects to assess for the deduction due to betterment.

▪ Higher output / productivity 

▪ Lesser manpower requirement 

▪ Lesser fuel consumption and operating cost 

▪ Additional range of function / compactness of machine, etc. 

If only an improved replacement can be obtained (the computer being a typical example) as the current nearest equivalent of the damaged machine, a suitable deduction will be made for the inherent improvements.

The following invaluable Publication has been referenced for this article:

“Reinstatement Basis of Settlement Practical Problems in Adjusting Losses by the CILA Property Special Interest Group”

The above interpretation is absolutely personal in nature and is not binding on any individual/ organization in particular.

 

 

CONTRACTOR’S ALL RISK POLICY FOR WORK CONTRACTS

A working knowledge of Works Contract under GST is much needed for inclusion of GST amount in loss assessment claims, especially for admissible losses covered under Contractors All Risk Policy. 

The Contractors All Risk policy is usually taken out by a commercial contractor or builder, but it can also be taken out by the owner of the project. 

Following points have been reproduced from: WORK CONTRACTS in GST Prepared by: National Academy of Customs, Indirect Taxes & Narcotics & Slide1 (gstcouncil.gov.in/sites/default/files/2024-04/workscontractservices_pra.pdf)

“Under GST laws, the definition of “Works Contract” has been restricted to any work undertaken for an “Immovable Property”

The Works Contracts has been defined in Section 2(119) of the CGST Act, 2017 as “works contract” means a contract for building, construction, fabrication, completion, erection, installation, fitting out, improvement, modification, repair, maintenance, renovation, alteration or commissioning of any immovable property wherein transfer of property in goods (whether as goods or in some other form) is involved in the execution of such contract.”

Thus, from the above it can be seen that the term works contract has been restricted to contract for building construction, fabrication etc. of any immovable property only.

Any such composite supply undertaken on goods say for example a fabrication or paint job done in automotive body shop will not fall within the definition of term works contract per se under GST.

Such contracts would continue to remain composite supplies, but will not be treated as a Works Contract for the purposes of GST.

As per Para 6 (a) of Schedule II to the CGST Act, 2017, works contracts as defined in section 2(119) of the CGST Act, 2017 shall be treated as a supply of services. Thus, there is a clear demarcation of a works contract as a supply of service under GST.

As per section 17(5) (c) of the CGST Act, 2017, input tax credit shall not be available in respect of the works contract services when supplied for construction of an immovable property (other than plant and machinery) except where it is an input service for further supply of works contract service.

Thus, ITC for works contract can be availed only by one who is in the same line of business and is using such services received for further supply of works contract service.

For example a building developer may engage services of a sub-contractor for certain portion of the whole work. The sub-contractor will charge GST in the tax invoice raised on the main contractor.

The main contractor will be entitled to take ITC on the tax invoice raised by his subcontractor as his output is works contract service.

However if the main contractor provides works contract service (other than for plant and machinery) to a company say in the IT business, the ITC of GST paid on the invoice raised by the works contractor will not be available to the IT Company.

Plant and Machinery in certain cases when affixed permanently to the earth would constitute immovable property. When a works contract is for the construction of plant and machinery, the ITC of the tax paid to the works contractor would be available to the recipient, whatever is the business of the recipient. This is because works contract in respect of plant and machinery comes within the exclusion clause of the negative list and ITC would be available when used in the course or furtherance of business.

Place of Supply in respect of Works Contract Works Contract under GST would necessarily involve immovable property.

In view of the same the place of supply would be governed by Section 12(3) of the IGST Act, 2017, where both the supplier and recipient are located in India. The place of supply would be where the immovable property is located.

In case the immovable property is located outside India, and the supplier as well as recipient both are located in India, the place of supply would be the location of recipient as per proviso to Section 12(3) of the IGST Act, 2017.

As per Section 13(4) of the IGST Act, 2017, in cases where either the Supplier or the Recipient are located outside India, the place of supply shall be the place where the immovable property is located or intended to be located”.

In summary: 

Input tax credit is available to both a builder and a taxable person while constructing plant and machinery. But input tax credit is not available to any taxable person who constructs on his own account even if it is for business use.

The above interpretation is absolutely personal in nature and is not binding on any one in particular.